0. Why gold is valuable: the story of gold in a nutshell

From mysterious fascination with the yellow metal to a world currency, its abandonment and gold's comeback

The common awareness about gold can be summed up in these few lines: first, gold was accepted across the globe as something extremely valuable, although it had little real use. Then, gold became the world's universal currency for many centuries. A few decades ago, gold was replaced by paper money not backed with anything. Finally, gold has come back to the investor's spotlight, but the middle class has not quite embraced it.

The following short explanation provides insight into why the yellow metal has enjoyed ongoing global trust for thousands of years and why you can share this confidence in gold, too.

How gold became valuable

For some reason, virtually every culture around the world believes that gold is valuable. This belief  almost certainly originated from the fascination with the shine (especially when exposed to the sun—a similar reason why diamonds are so sought after), the warm color, gold's imperishability and scarcity. It is a natural law that things that are pretty and rare at the same time, become valuable.

Over time, the asset most precious to humans became a means of payment for a simple reason: it concentrates the highest value in a limited space. The more value is contained in a coin, the easier and cheaper storage and transactions become. It is less costly to transfer a few gold coins than to transport cows, wood or firearms. Just like you strive to keep your banking fees low, our ancestors had the same desire for efficiency when it came to financial matters.

As the time went by, gold moved from our bodies to wallets and underground vaults and our eyes forgot how pleasing the sight of gold can be. (Also, the modern industry has produced many alternatives of shine and glitter.) This change meant that gold started building its reputation in the investment and banking world. It's reputation grew so strong that many times in history, gold was the world's number one currency. Of course, the fact that gold can't be artificially produced or printed by any government helped immensely. Expressions such as "good as gold" became commonplace and in most countries still are to this day.

The end of the golden era

The United States brought an end to the golden era in 1971 when President Nixon declared that the dollar would not be fully backed by gold anymore (until then, dollar banknotes could be redeemed in gold, at an official exchange rate of $35 per ounce). This action, known as the "Nixon Shock", gave the U.S. government the freedom to control the flow of dollars in and out of the economy more easily. Without the link to gold, the Federal Reserve could now print (and lend) as much money as it pleased. Since then, the gold in Fort Knox shrank to less than 1% of the value of the currency in circulation. The United Kingdom and other European countries left the gold standard even earlier and the gold backing of their currencies is equally as small today.

Even though one part of the world may get rid of gold as the ultimate reserve, history shows that the demand for gold may rise in other regions because of untrustworthy rulers or citizens who prefer gold over the paper currencies issued by their unstable governments. For instance, the demand for gold has been very high in India and China as well as the Gulf countries. And it has started to rise again in Europe and America.

Along with the yellow metal's use in medicine, telecommunications and the computer industry, the  worldwide demand ensures an ongoing presence of retail and wholesale buyers, even in times of paper money. These buyers are willing to purchase gold and sell it at a profit to businesses and in regions where the demand is high, thus guaranteeing that the price of gold will never collapse. Which is, after all, the most important thing to any investor—you always need a buyer, otherwise your asset is worthless. If one thing can be said about gold, never in history has there been a lack of buyers.

No need for gold in the West—as long as paper money works

In the prosperous West, and particularly on its main street, gold has been forgotten like the ugly duckling. The gold price slid under $300 per ounce. Until about 2000, three or more generations of Westerners had no obvious need for gold. The dollar and the European currencies were halfway stable, markets were growing, debt and inflation were largely contained—who would need a safe heaven? Until 2000, any investment was considered acceptably safe. But suddenly, gold re-appeared as if out of nowhere, causing many people to ask themselves if this is the next bubble, not understanding the real cause of gold's "return to fame".

The comeback of gold is a surprise to some and an expectation turning into reality to others. Monetary historians will tell you that it was just a question of when, rather than why: throughout the history, gold often found itself in the shadow of paper currencies, as long as these were properly managed. But if the government in charge tinkered with the currency too much or printed amounts larger than required by the size of the market, markets and savers got irritated—and gold would reemerge to a new prominence.

The comeback of gold

Currently, history seems to be repeating itself: governments have been printing money in amounts that are in no relation to the economy (in the past ten years the money supply in the West doubled while the economy shrank); markets got irritated because the overly abundant amount of credit made people invest recklessly into anything in sight and drove the prices up—this resulted in some of the worst market crashes in recent history (dot-com bubble and the housing bubble, with a financial crisis as an aftermath). As a result of the turbulence, the popularity of gold surged, gold tripling in price since 2000.

But this news seems to have stayed behind closed doors. Why has the middle class chosen to opt-out from our grand-grandmothers favorite form of saving and forgo the profits of gold ownership?

The explanation may be simpler than one thinks: today, gold's reputation among the broad public is no better than that of stocks, mutual funds or anything that even remotely smells of the Wall Street. Those automatic STOP signs that instantly spring to mind when an annoying broker calls, apply to gold just like to any other investment asset.

Gold—just another Wall Street fad?

The hazy notion that gold is just some speculative niche commodity has overshadowed the big picture. Few people know that virtually no gold is traded on Wall Street (less than 1% of the world's gold). Rather than stocks, funds or commodities, gold should be compared with currencies. No company (and their stocks), no mutual fund and no other commodity comes close to the total value of the world's gold (see table below). That's why the gold price is more resistant to speculation than any of those assets. Only major currencies come close to gold's stability.

  Total value (2010)
World's gold $6.0 trillion
Dow Jones (top 30 U.S. companies combined) $3.5 trillion
Vanguard (largest mutual fund group) $1.0 trillion
World's annual steel production $0.9 trillion
Fidelity (third largest mutual funds group) $0.7 trillion
ExxonMobil (largest company) $0.3 trillion
Microsoft $0.2 trillion
General Electric (GE) $0.15 trillion

 

Most importantly, gold works in the opposite way of Wall Street products or most currencies—gold appreciates when markets are in bad shape. Due to its stability and this opposite trend, gold has been dubbed a safe heaven. It enables investors and savers to weather a financial storm and then set out for more profitable investments after the storm is over. The nice side effect is that not only they survive the storm, but many times they make a profit on top of it.

Short-sighted misconceptions as the one shown above prevent people from investing in gold, and sadly, make room for other investments that put their savings at a higher risk. Therefore, the rest of this guide focuses on clearing up these concerns. The following five points sum up the five most common misconceptions and provide an opposing view.

 

You have just read:
0. Why gold is valuable: the story of gold in a nutshell — From mysterious fascination with the yellow metal to a world currency, its abandonment and gold's comeback (7-8 min)

Continue reading:

Five common concerns—five steps to understand gold

1. Value of gold during major economic downturns — "I can't imagine gold would be worth anything in times of a severe economic downturn when food and basic goods are scarce." (2-3 min)

 

 


 

0. Why gold is valuable: the story of gold in a nutshell — From mysterious fascination with the yellow metal to a world currency, its abandonment and gold's comeback (7-8 min)

Five common concerns—five steps to understand gold

1. Value of gold during major economic downturns — "I can't imagine gold would be worth anything in times of a severe economic downturn when food and basic goods are scarce." (2-3 min)

2. Should you insure your pension & retirement in gold? — "My government pension (social security, etc.), and an additional savings plan (or insurance) will provide more than enough for my retirement.” “My savings are locked in a special account (IRA, 401k, SSAS, SIPP, etc.) and would be taxed if moved elsewhere. I have no reason to invest in gold." (10-12 min)

3. Is the gold price too high? Has gold peaked? — "I am interested in gold, but the price is too high. What if gold has reached the peak?" (2-3 min)

4. Recent movements in the gold price. Need to worry? — "The gold price moves too much for my taste. What if gold makes a major drop and I lose a lot of money?" (1-2 min)

5. Buying gold bars and gold coins online and offline — "We live in times of electronic money: gold is impractical. Going back to gold coins and bars would simply be a hassle, if not impossible." (2-3 min)








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