Why We Invested in Gold
We recently invested in gold.
This was not the first time; between the two of us we first invested in gold in 2010, and have invested more at several times since.
In this article we will lay out in simple terms why we invested in gold, and why we believe it’s a very important asset to hold in one’s portfolio.
It is not meant to be an exhaustive analysis of gold, but rather a summary of what we believe to be the most important points.
What is Gold?
Most people in the investment industry would say that gold is a commodity, just like oil or copper.
However, we disagree. We view gold as a form of money, and we believe most average people would agree with us. If we gave you a gold coin, you would inherently know that it’s a form of money.
Gold has been money for thousands of years. It has certain properties that make it a very good form of money, such as its durability (it doesn’t erode or rust), which makes it a good store of value.
But if gold is money, why don’t we use it in our day to day lives?
These days we use paper currencies (fiat money) instead of gold because it’s not convenient to carry around large amounts of gold (and silver) when you do your shopping.
However, back in the day that’s how people transacted; they paid in physical gold. Eventually, for convenience, people started storing their gold in bank vaults, and the bank issued a claim check (a banknote) to the owner of the gold.
It was much more convenient to carry around a piece of paper that proved you owned gold in a vault, rather than logging the gold around with you.
People could exchange these bank notes for goods and services, transferring the ownership of the gold, without actually having to exchange the physical gold.
But banks being banks, they sometimes didn’t play by the rules, and they would create more banknotes than there was gold in the vaults. As a result, bank runs would occur as people realized there was not enough gold to back up the paper banknotes.
A bank run is when a large number of depositors withdraw their money simultaneously because they are afraid the bank doesn’t have enough money to pay them back.
People would want their gold back, the bank could not deliver, and the bank would go under. There was a natural “checks and balances” mechanism in place - if a bank created too many banknotes, it risked going bankrupt.
Similarly, national currencies used to be backed by gold. For example, the U.S. dollar used to be redeemable for gold; the dollar was on a gold standard.
However, in 1971 Nixon took the U.S. off the gold standard, and by default took the rest of the world off the gold standard as well, because all the major currencies were pegged to the dollar.
A gold standard limits the amount of currency that a country can print. If a country prints more currency than they have in their vaults, they will run out of gold if people start asking for their gold back.
However, when the gold standard ended in 1971 countries could print as much money as they wanted.
That might sound strange to you, but it’s how the current global monetary system works. Central banks can simply print (or create digitally) money out of thin air, at will.
Why is Money Printing Bad?
Over the last several years, and especially in 2020 as a response to Covid, central banks across the world have been printing huge amounts of money.
But why is that a bad thing? Aren’t they just trying to keep the economy afloat?
In our humble opinion a central bank should step in and provide liquidity to the market in crisis situations (e.g. the 2008 financial crisis or the Coronavirus crisis) to prevent the financial system from freezing up.
However, a central bank should not print money for years and years and pump it into the banking system to try to keep the stock market afloat, or prevent a recession. That creates distortion in the markets, and it devalues the currency, which is bad for the average person.
To expand on these points it’s worth quickly explaining what money actually is. Money is a medium of exchange. Money is what makes it possible for our modern society to function. Without it, we would have to use a barter system, which is extremely inefficient.
Money in itself isn’t valuable; a gold coin or a dollar bill won’t do you much good in and of themselves. It’s the goods and services - the real assets (e.g. cars, houses, buildings, farms etc.) - that you can buy with your money that represent the real value.
When you print more paper money, you are only printing more of the medium of exchange; you are not printing more real assets. And since more paper currencies are chasing the same amount of real assets, the result is inflation.
Because if the amount of real assets grows at a steady rate, but the amount of paper currency explodes, it will naturally take more of the paper currencies to buy the same amount of real assets. The value of the paper currency has depreciated because for each new unit of currency that is created, the existing units of currency are worth less. It’s simple supply/demand dynamics.
That’s why inflation has accelerated since 1971, when the gold standard ended.
Therefore, in the long run money printing doesn’t actually create prosperity. On the contrary, it destroys it because it devalues the currency, which leads to inflation.
People who have worked hard to earn a living, and save money, see their savings devalued when central banks print more currency out of thin air. It’s an unfair mechanism.
But it happens slowly, so most people don’t notice it.
Once countries start to devalue their currencies, they start declining. A country can’t slowly devalue its citizens’ savings, and expect to prosper.
This has happened again and again throughout history; it happened in ancient Greece, in ancient Rome, in Weimar Germany, and it’s currently happening in Venezuela, and it never works.
Gold as an Insurance Policy
Given that central banks no longer have a restriction (a gold standard) on how much currency they can print, they have been printing like crazy.
That means that they are devaluing the currency that people have worked hard to earn and save. We therefore believe it’s important to protect one’s assets by buying some gold. It can be seen as an insurance policy for one’s portfolio.
Central banks can’t devalue gold. Gold will maintain, and even increase, its purchasing power as the amount of paper currency increases. Gold tends to do an “accounting” for the amount of printing that the central banks do - as the central banks print more, your gold will be worth more (and your paper currency will be worth less).
The chart above shows only the money printing in the U.S., but the situation is similar for almost all (if not all) major countries around the world.
We are not saying that one should allocate one’s entire portfolio to precious metals, but we believe that an allocation of 10% is reasonable. Or someone can allocate more if they are really worried about the future of the currency system.
We live in very strange times, not just because of Covid, but because of how the global monetary system works. Countries used to be on a gold standard, it was the common thing to do, but since 1971 there has been no limitation on how much currency that central banks can create.
That means they have been slowly devaluing their currencies ever since, and it accelerated after the 2008 financial crisis, and then exploded in the Coronavirus crisis. And they will not stop any time soon. On the contrary, they are likely to speed up the process.
We therefore believe it’s only sensible to protect one’s portfolio with some gold.
And if we are wrong - and currencies maintain their purchasing power and there is no inflation - we own a bit of gold, which is not such a bad thing.
Lars and Roshni
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