The Real Reason Why You Should Buy Gold

Imagine the following scenario: you’re a homeowner with no home insurance. The good news is that home insurance rates keep dropping. In fact, they’ve been dropping since 2011. Should you get coverage now?

Most people would say “of course.” Not that we expect a fire to burn down our house anytime soon. But, it’s nice to have insurance in place, just in case that happens. It’s the prudent thing to do.

That’s exactly the scenario we have today in gold, which could be viewed as portfolio insurance. Unfortunately, a lot of investors don’t understand the role the shiny metal could play in a diversified portfolio. And, they end up viewing gold simply as a speculation that has gone wrong. Others continue to think gold is just for fringe types. So, they pass up the opportunity to buy insurance on the cheap.

It’s easy to understand why most people don’t really understand physical gold. It’s not your average investment and the meaning of money is easily forgotten by many of us.

“Money is Gold, and Nothing Else.”
See, throughout the years, lots of different things have been used as money. For example, cows, salt, and sea shells have all been used as a medium of exchange and a store of value. But, gold has a more enduring standard of value than anything else that’s ever been tried.

Back in the 4th century B.C., Aristotle pointed out that good money must meet four specific criteria: it must be durable, portable, divisible, and have intrinsic value. Gold meets all these criteria. It’s been the choice of money for over 5,000 years because it’s valuable, durable, divisible and relatively portable.

It’s durable because it stands the test of time and the elements. It does not fade, corrode, or change through time. It’s portable because it holds a high amount of “worth” relative to its weight and size. It’s divisible because it’s relatively easy to separate and re-combine without affecting its fundamental characteristics. And, unlike paper money, it has intrinsic value because it’s not anyone else’s liability.

Legendary banker J. P. Morgan said it best: “Money is gold, and nothing else.”1

Physical Gold: Neither An Investment Nor A Speculation
You can look at gold as an investment, a speculation, or as insurance. A lot of people don’t understand gold because they look at it as an investment. If you look at gold from this point of view, you may end up with the wrong conclusion. Warren Buffet is an example. Here’s what he said about gold during a 2010 interview:

“For all the gold that’s ever been mined, you could buy every acre of farmland in the U.S. and 10 companies the size of ExxonMobil… and still have $1 trillion left over. Would you rather have a shiny cube of metal, 67 feet on a side… or trillions of dollars of assets that actually produce wealth?”2

Buffett doesn’t like gold because he thinks it has no utility. He thinks gold has no intrinsic value because it produces no cash flow. In a way, he’s right. Most of the gold in the world just sits around collecting dust. But, that doesn’t mean gold has no value. It simply means gold cannot be considered an investment because it cannot produce more capital.

But, if gold isn’t an investment, what is it?

You can certainly view gold as a speculation, an allocation of money to profit from distortions in the market. Gold was a great speculation from 2002 to 2011, when the average price went from $309 to $1,571 an ounce.3

There’s nothing wrong with betting on the direction of gold prices. And, there are multiple vehicles that allow you to do that: exchange-traded funds, precious metals mutual funds, gold mining stocks, etc.

But, I’m talking specifically about physical gold, and that shouldn’t be viewed as an investment or speculation. You should view it as portfolio insurance.

Gold Is Insurance Against The Dangers Of A Paper Money System
The Federal Reserve is at the bottom of the U.S. banking system. As a lender of last resort, it has the unique ability to print as much money as it wants in order to have enough to lend into the banking system.

That’s essentially why the U.S. dollar is a poor standard of value. It can be created out of thin air. As American investors, we have most of our assets denominated in U.S. dollars, which is why it makes sense to hold some physical gold as insurance.

Sure, gold yields nothing. It doesn’t pay dividends or interest. But, that’s not why you should consider buying it. And, you shouldn’t buy it simply because you expect the price to move higher. But, it’s an inherently limited resource and one of the more enduring forms of wealth in history.

One buys physical gold to preserve the purchasing power of the wealth they’ve created, and to maintain a truly diversified portfolio. The time to buy insurance is before the accident happens, not after.

Until the next Daily Pfennig® edition…

Chris Gaffney, CFA
EverBank World Markets, a division of EverBank