Hedging Chaos: The Case for Investing in Gold

Gold is the investment that everybody loves to hate. But does it still offer a valuable hedge and opportunity for tough times ahead?

With the cryptocurrency narrative buzzing and many stock valuations at all-time highs, now feels a good time to talk about the asset everybody loves to hate. Yes, it’s our good old friend, gold.

Gold has had a tough time of late. Amidst the most aggressive monetary expansion the world has ever seen, the response of gold prices has so far been… well… underwhelming.

But it may be foolish to write off gold as an investment just yet. Black swans wait in the distance, and gold remains one of the most important chaos hedges at our disposal.

With that in mind, the purpose of this article is to launch something of a defense of gold. But before we dive in, I want to give some framework for navigating this article.

I intend to cover a few different considerations. Some of these thoughts will be “evergreen” (meaning they will apply whenever you happen to read this article) and some of these insights will be with current economic conditions in mind.

We’ll start with some of these evergreen considerations, beginning by looking at the traditional function of gold in an investment portfolio. Then we’ll turn to strategies for buying gold, and then we’ll look at some of the best approaches to storing it.

Thereafter, I want to dive into the case for gold now (early September 2021). I’ll set out four central arguments for including some gold in your portfolio. Then I’ll explore some of the most popular counterarguments and we’ll see where we end up.

With that, let’s get to it.

Why Is Gold the Chosen One of History?

A long time ago, gold was used as currency, directly exchanged for goods and services. As currency systems developed around the world, central banks instead offered their own paper currencies backed by the promise of gold. Later, as most of us know all too well, these “gold standards” gradually disappeared from currencies across the world, leaving us with today’s “fiat currencies”.

Key Concept: Fiat Currency. A fiat currency is a state-issued currency that is not backed by a commodity like gold. This gives central banks more control over the overall economy by providing the power to “print” more of that currency.

But why gold? Why did humans choose to trade and store wealth in a metal that seemingly has no utility, perhaps with the exception of its capacity to signal status?

Gold has been regarded as a “store of value” throughout history for several important reasons:

  1. Durability: Gold is a resilient metal that has stood the test of time as a store of value. There is evidence both of its use as jewelry and a standard of exchange dating back seven millennia.
  2. Scarcity: Gold is scarce and global supply is finite. According to the World Gold Council, approximately 201,000 metric tons of gold were above ground in early 2021, with about 48,000 metric tons still accessible in the ground. Assuming annual production of 3,000 tons continues, that means all accessible gold will be out of the ground by 2037. To give some perspective on what these quantities look like, commentators like to point out that a stacked cube of total global gold would just about cover a tennis court.
  3. Transportable and exchangeable: Gold was easily exchangeable (items could be prices in ounces of gold) and easily transportable (gold could easily be carried and moved). These characteristics carry less weight in a post-analog world where money can be moved between accounts and countries with relative ease.
  4. Beauty: Gold has unique physical and psychological allure. The atoms in gold are heavier than silver and other metals. Combined with a unique combination of colours, these properties give gold its long-sought shiny appearance. Gold was – and perhaps remains to a lesser extent – a means for human beings to shake their tail feathers.

Gold has been used as money throughout history for these primary reasons. But given a piece of physical gold doesn’t generate us income or offer much real-world utility, what role does it serve in an investment portfolio?

The Role of Gold in Your Investment Portfolio

Economic history tells us that gold serves two important roles in an investment portfolio. First, it is a solid long-term store of value and second, it is a short-term crisis hedge.

Role 1: Long-Term Store of Value

The key point here is that due to its characteristics – and whether you like it or not – gold is a proven “store of value”. That means it is an asset that maintains its value in real terms over time.

Put another way, the long-term role of gold investing isn’t necessarily to grow your wealth; it is first and foremost to preserve it.

This idea clearly plays out in the data over the long run. Take a look at this graph of UK RPI (Retail Price Index) versus gold on an indexed basis from 1974. In 2021, you can see that gold is outperforming RPI after a period of underperformance in the early 2000s. In other words, gold has more than retained its value versus official inflation statistics. But of course, when we consider many of the inflation suppressing tricks of the trade from the statisticians, the recent gap is likely to be a lot smaller versus the true level of inflation in the economy.

We can simplify this analysis a little by looking at the average price of a UK home in ounces of gold. Going back as far as 1995 (which is the furthest I could find), you can see that we started off at around 200 ounces per home. In the build up to the subprime mortgage crisis, the price of gold disconnected from home prices. But since 2010, the price of a home in gold ounces has fluctuated but settled back at 1995 levels.

In other words, if you’d stuck it out since 1995, your gold would still buy you roughly the same amount of bricks and mortar in 2021.

But if you took the chance and played the right side of this ratio over the last 25 years, you could have profited considerably. Better still, if you’d anticipated economic crises, you’d have outperformed almost every other asset class.

 Role 2: Short and Medium-Term Crisis Hedge

The crisis is where gold comes into its own. It’s the “relic” that everybody loves to hate until a gigantic crisis slaps them in the face.

Gold has historically served investors well in providing protection against currency crises, hyperinflation, credit crises, recessions and stock market crashes – or a combination of all of the above. Every decade or so, gold has a formidable record of rising from the ashes as wealth preserver during crises.

Just look at how it performed during four of the most significant recessions in the last 50 years.

If you’d invested 6 months before each of these recessions and sold 6 months after the US economy exited the recession, you’d have substantially outperformed US equity returns in each case. Why? Because as much as everybody loves to hate on gold, in crises investors have an established habit of running to gold as the safe haven.

This is why so many experienced investors hold an allocation of gold as insurance. They don’t expect spectacular returns during times of economic prosperity, but they trust in gold to provide protection and even outperformance in times of economic hardship. Food for thought for anyone trying to build a more defensive financial independence portfolio.

How to Buy Gold

So how do you buy the stuff?

There are a few different options to gain exposure to gold in an investment portfolio.

Physical Ownership: You can purchase physical gold bullion bars and coins directly from national mints like the Royal Mint and US Mint or you can buy bullion bars and coins from private distributors. In a true crisis, physical gold is your insurance, eliminating third parties if you store it at home. But the disadvantages of physical gold include lower liquidity (it takes longer to sell) and security risks.

Exchange-Traded Commodities and Physical Trusts: You can gain exposure to gold prices by purchasing exchange-traded commodities (ETCs). But be careful. Many ETCs use a complex range of derivative instruments and cannot guarantee full allocation. An alternative is a physical gold trust (see the Sprott Physical Gold Trust, for example).

Gold Mining Stocks: One alternative is to gain exposure to gold by owning gold mining stocks. Gold mining stocks will tend to outperform gold price gains if timed correctly, but they also tend to get hit hard with the rest of the stock market in the initial phases of stock market crashes.

How to Store Physical Gold

If you opt for physical gold ownership, there are three main options for storage.

  1. National mint vault: You can pay a percentage fee to store the gold with your national mint. The key caveat here is that your appetite to do so depends on your trust in your government. Government gold seizures have happened in history, but are perhaps less probable in the 21st century.
  2. Third-party secure vault: An alternative is to use an insured third party to store the gold. There are a wide range of options, but risks and legal terms need to be carefully weighed up.
  3. Home storage: This removes the third-party storage risk, but can pose security risks of its own. The less people this is shared with the better.

Why Gold Now?

With the basic principles of gold out of the way, let’s turn to why gold might be a good play now.

The usual caveats apply. I’m not a gold expert, I’m not a financial advisor, and I’m certainly not recommending you chuck everything at gold. The principles of diversification remain hugely valuable, particularly in such uncertain times.

From a 30,000-foot view, there are four main reasons why gold may offer good value right now.

Reason #1: Currency Debasement

Fiat currencies continue to be smashed by unprecedented levels of quantitative easing (QE). Currently, the inflationary effects of these policies have played out in equities and commodities, and also in some of the highest levels of consumer price inflation seen for decades. Central banks have said the inflation is “transitory” and indicated that they will taper monetary expansion if it’s sustained. But whether it is transitory or not, central banks are stuck between a rock and a hard place. They are almost certain to push the monetary stimulus button at the first sign of new stock market trouble.

Key Concept: Quantitative Easing. QE is a process whereby central banks create new currency and then inject it into the economy by purchasing government bonds or other financial assets. The process is colloquially referred to as “money printing” – and frankly, it’s bonkers.

Reason #2: Programmable Money

Not content with their current monetary tools, central banks are seizing the current crisis as a launch platform for CBDCs (Central Bank Digital Currencies). CBDCs will digitalize fiat currency, removing anonymity, making currency programmable and facilitating a transition to negative interest rates through the removal of physical cash as legal tender. I will explore the full implications of CBDCs another time, but they will surely create further momentum behind alternative forms of money, including cryptocurrencies and yes, gold.

Reason #3: Black Swan Insurance

With the COVID story still its infancy, authoritarianism rising across the western world, national debts at their highest levels ever, the financialization of everything, a growing crisis in Afghanistan, and asset prices looking extremely high by conventional measures, it may pay to hold some insurance. The “Everything Bubble” won’t last forever.

Interestingly, Palantir Technologies, a big data analytics company that works closely with the US government, recently declared a $50 million purchase of gold bars, stating that it was insurance for another “black swan event”. Not a colossal figure by any stretch, but an unusual declaration from a public tech company.

Reason #4: Relative Valuations

Gold looks “good value” (whatever that means in today’s terms) relative to historic ratios versus stock indexes, money supply and numerous other key assets. The world’s leading gold and silver miners have rarely looked in better financial health and valuations look favourable versus the overheated end of stock market.

In summary, as we head into unprecedented monetary and political territory, I believe gold looks like a good contingency play right now. I may yet be proven wrong, and in many ways, I wouldn’t mind. After all, the world tends to be a better place when gold isn’t surging in value.

Counters to the Counterarguments

With the pro-arguments out of the way, it would be wrong to ignore some of the common counterarguments. So with that, let’s explore some of those cases that keep popping up.

Counterargument 1: Bitcoin is replacing gold.

The central argument here is that people (particularly young people) are turning away from gold and instead using Bitcoin as a store of value. Now, it would be hard to dispute that some of the inflows that may have gone to gold have instead gone to Bitcoin and other cryptocurrencies. But when some argue that gold is useless because we have Bitcoin, there are a few points to consider.

The simple reality is that lots of the previous arguments for gold are also probably good reasons to own Bitcoin. Bitcoin has a limited supply of 21 million coins and doesn’t present the logistical concerns of physical gold ownership. It’s also divisible and transferable (albeit with limited efficiency). As a result, many now refer to it as “digital gold”.

But here’s the problem. Bitcoin hasn’t been used as a store of value for seven millennia. Bitcoin can’t be physically held or worn. And perhaps more importantly, the assets behave in completely different ways. Bitcoin is a risk-on asset. Gold is a hedge against chaos.

Compare and contrast the behaviour of the two assets during the March 2020 COVID recession. This brief market crash saw gold surge to all-time highs while crypto took a beating.

Granted, the story changed dramatically thereafter as the economy returned to nominal growth. Cryptocurrencies soared to new highs while gold gave up some of its gains. But the point stands: these two asset classes serve different purposes at different times.

The reality: Bitcoin maximalists that dismiss the merits of gold ignore its unique capacity to weather economic storms. Gold bugs that dismiss cryptocurrency as worthless hype ignore the emerging significance of decentralized finance, tokenization and digital ownership.

It needn’t be a zero-sum game. Both can win.

Indeed, when we look at current allocations of household savings, there is plenty of runway for further inflows. Even a small increase in allocation to both asset classes will dramatically move the dial.

As confidence in fiat currencies diminishes over the medium term, it’s likely that both assets will do well. And while gold may be considered a relic by crypto maximalists, there is enough historical evidence to tell us its time in the light isn’t over yet.

Counterargument 2: Gold will be mined from asteroids.

The argument here is that at some point in the future, we will be able to send machines to land on asteroids, mine gold and bring that gold back to Earth.

I’m not making this up. There are companies that are seriously exploring this idea, proposing the design of spacecraft to gather hundreds of tons of material from asteroids.

Seems concerning for gold bugs, right? Asteroid mining would dramatically increase the overall supply of gold, pushing down the gold price in the process.

Fortunately, there is a fundamental problem with the asteroid mining counterargument: the economics.

Mining gold from asteroids and transporting gold back to Earth would cost a fortune. And why would a private company incur this fortune without a higher commodity price to support it?

Don’t believe me? Look at the academic analysis. A 2019 analysis looked at the economic viability of asteroid mining for platinum, concluding that it was very unlikely.

Don’t buy the academic view? Look at the history of companies in this industry. Several companies have established high-profile investment for the idea, only to give up altogether after a few years. Check out Planetary Resources and Deep Space Industries for an idea of the gap between hope and reality.

So while we might get there one day if the cost-benefit analysis stacks up, asteroid mining is unlikely to present a threat to gold in the near future.

Counterargument 3: If the world is ending, you’re better off owning guns.

This may well be true, but we’re not planning for the end of the world here. We’re planning to protect our real wealth and perhaps even grow our real wealth.

I’ll say no more on this one. Feel free to plan for the end of the world if you want to. I’m hoping things don’t get that bad.

Summary

We’ve covered a lot of ground, so let’s recap in a few bullet points:

  • The role of gold is to act as a long-term store of value or a short-term crisis hedge.
  • History shows us that gold tends to outperform other asset classes during periods of economic hardship and political turmoil.
  • The current monetary and political landscape may give rise to another of these periods of economic crisis, potentially positioning gold investors to take advantage.
  • While alternative assets like Bitcoin are being coined the new gold, obvious differences in asset characteristics, price behaviour and sentiment suggest gold still has an important role to play over coming years.
  • We can gain exposure to gold through investment in physical gold, ETCs, physical trusts and gold mining stocks.

There are, of course, no guarantees. But gold has a history of proving people wrong, time and time again. Just when we’ve written it off as a failed store of value, an ancient relic. Just when the herd has ploughed into everything else. Gold shows up as everything else implodes.

Gold is insurance for something we don’t want to happen. It’s the safety net when the invisible hand throws us out of the window. It’s the proven hedge against chaos.

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