Why Gold Matters

By Sham Gad AAA

While economic recessions usually draw many comparisons to The Great Depression, so far there has been little (if any) historical precedent to the monetary and fiscal stimulative policies that our country embraced in the fall of 2008. For many investors, gold has never been seriously considered as a long-term investment. (To learn about the factors that led to the Great Depression, see What Caused The Great Depression?)
Yet in investing, to completely dismiss an idea simply based on reasons that are ultimately based on pre-existing views is not an intelligent idea. If anything, one should examine the situation for his or herself and come up with an independent reason as to whether or not an investment is to be made.

The Gold Conundrum
The topic of investing in gold came to the forefront of many investors' minds during the 2008-2009 recession. The most obvious reason for this is due to the rise in the price of gold. Market watchers love to sensationalize any stock or asset class that is experiencing a rise in price as the next possible investment to latch on. Yet the rise in the price of gold happened largely due to people buying physical gold or betting on the shiny metal through various investment options, such as ETFs or gold miner stocks.

Problems with Gold as an Investment
Before jumping on the gold bandwagon, I often find it instructive to first examine reasons why investing in gold holds fundamental problems. Only by realizing these issues will you be able to make an intelligent decision with regards to gold investing.

The main problem with gold is that, unlike other commodities, gold does not get used up. Once gold is mined, it stays with you. A barrel of oil is turned into gas and other products that are used up. Grains are used to feed us. Gold on the other hand is turned into jewelry, used in art, or stored in vaults. Jewelry can be melted to make other things, but gold's chemical composition is such that it cannot be used up. The only way gold disappears from our society is if it lost or buried.

Because of this, the supply demand argument that can be made for commodities like oil, copper, grains, and so forth doesn't hold up for gold.

History Overcomes This Problem
However, unlike other commodities, gold has been with human societies since the beginning of time. Empires and kingdoms were built and destroyed over gold. As societies developed, gold was universally accepted as a satisfactory form of payment. In short, centuries of history have given gold a power unlike any other commodity on the planet. Peter Bernstein's book "The Power of Gold" offers a wonderful look at gold's hold on societies over the centuries.

And that power has never really disappeared. The U.S. monetary system was based on a gold standard until the 1970s. Proponents of the gold standard argue that this monetary system effectively controls the expansion of credit and enforces discipline on lending standards since the amount of credit created is linked to a physical supply of gold. It's hard to argue with that line of thinking after nearly three decades of a credit explosion in the U.S. led to the financial meltdown in the fall of 2008. (Learn about the gold standard in The Gold Standard Revisited.)

In investing, you can't ignore the effect of human psychology when it comes to gold. Gold has always been a go-to investment during times of fear and uncertainty. Periods of fear and uncertainty go hand in hand with economic recessions and depressions. The Great Recession of 2008 is set to have profound effects on our economic system for many years to come. These periods of market uncertainty tend to benefit gold.

From a fundamental perspective, gold is generally viewed as a favorable hedge against inflation. Gold functions as a good store of value against a declining currency.

Investing in Gold
The easiest way to gain exposure to gold is through the stock market, in which you can actually invest in actual gold bullion or gold mining companies. Investing in gold bullion won't give the leverage that you get from investing in gold mining stocks. As the price of gold goes up, miners' higher profit margins can boost earnings exponentially. Suppose a mining company has a profit margin of $200 when the price of gold is $1000. If the price of gold goes up 10% to $1100 an ounce, the operating margin of the gold miners goes to $300, a 50% increase.

Of course, there are other issues to consider with gold mining stocks namely political risk (since many operate in third world countries), and maintaining gold production levels.

The most common way to invest in physical gold is through the SPDR's Gold Shares (NYSE:GLD) ETF, which simply holds gold. When investing in ETFs, pay attention to net asset value (NAV) as sometimes the purchase can exceed NAV by a wide margin, especially when folks are optimistic.

Gold mining companies include Barrick Gold (NYSE:ABX), Newmont Mining (NYSE:NEM), Goldcorp (NYSE:GG), and Anglogold Ashanti (NYSE:AU). Passive investors who want great exposure to the gold miners may consider the Market Vectors Gold Miners ETF (NYSE:GDX) which includes investments in all the major miners.

Alternative Investment Considerations
While gold is a good bet on inflation, it's certainly not the only one. Commodities in general benefit from inflation, since they having pricing power. The key consideration when investing in commodity-based businesses is to go for the low-cost producer or producers. More conservative investors would consider inflation-protected securities like TIPS. The one thing you don't want is to be sitting idle in cash thinking you're doing well when inflation is eroding the value of your dollar.

For younger investors, the best investment is to invest in yourself. Anything that increases your earnings power is a wonderful hedge against inflation.

Conclusion
Gold certainly matters, especially during times of uncertainty surrounding government monetary and fiscal policies. Monetary policies that depreciate the dollar and lead to high inflation will always benefit gold.

For related reading, take a look at 8 Reasons To Own Gold and Does It Still Pay To Invest In Gold?

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