Understanding Gold Fundamentals

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on Dec 4, 2020

Updated: Dec 19, 2022

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Gold is around for thousands of years and has fascinated humankind ever since. Its role in societies evolved in time, from gold coins at the heart of the fractional reserve system (i.e., promissory notes were first issued by goldsmiths against holding gold as collateral) to the basis of the financial system during the gold standard.

People are familiar with the gold standard period following the Bretton Woods system, but the gold standard was even more successful prior to World War I. We can say that a true international gold standard existed from 1871 to 1914, marked by world peace and prosperity.

Gold as an Investment in the 21st Century

Nowadays, gold is valued for its scarcity and for being a store of value. Sometimes it does act like the two characteristics are not there anymore, but this is only due to its defensive qualities. For instance, consider the move in March 2020 to lower the price of gold.

Gold lost about twelve percent of its value, albeit for a brief period of time only. So, where were gold’s defensive qualities? As it turns out, it wasn’t about gold – but about the risk-on/risk-off environment. Investment managers in the 21st century build portfolios according to the mandate and in accordance with investors’ risk profile. Their aim is to maximize returns and, in a risk-off environment, to minimize losses. Thus, selling gold to get dollars was just another way of liquidating an asset to meet the portfolios’ investment objective.

Therefore, we can say that market’s volatility affects the price of gold but without affecting its defensive qualities. After all, compared to stocks or other assets, gold declined less in a risk-off environment.

Another important fundamental characteristic of today’s gold market is its liquidity. Gold comes in third place, following the U.S. 1-3 year Treasuries and the S&P 500 index in terms of the average daily trading volume. Other asset classes fall behind, like UK gilts, the Euro/Sterling or Euro/Yen, and so on.

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Finally, investors like gold because of its inflation-protection attributes. After the U.S. dropped the gold standard in the 1970s, gold rallied more than seven hundred percent due to fears of high inflation. We may say that similar fears were responsible for the price of gold reaching a new all-time high above $2,000 this year, as more than twenty percent of all existing dollars were created this year.

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