In today’s ever changing world of investment options, gold has stood the test of time. It continues to be a symbol of wealth and its investment appeal can be traced back to its intrinsic qualities and historical significance. The physical characteristics combined with its storied past as a store of wealth and form of currency are a strong foundation for its desirability.

In this article we shall delve into the history of gold and the reason why investors turn to gold in a time where new investment tools keep emerging. We shall look at its effectiveness as a hedge against inflation and currency devaluation,its performance as a stabilising market force and its dynamics in terms of supply and demand. Furthermore, we shall look at how investors can go about incorporating gold in their portfolios and what factors to consider before doing so.

The Rise and Fall of the Gold Standard

The allure and significance of gold date back thousands of years. Its role as a currency solidified over centuries, supported by its rarity and universal appeal of its lustre, leading it to become the backbone of the global economy with the gold standard. The monetary system, where paper money was directly convertible into preset amounts of gold, provided a stable economic base by ensuring that governments could not print money indiscriminately.

However, while the gold standard helped stabilise currencies, it also made implementing monetary policies incredibly difficult. During economic downturns or other major crises, countries could not easily increase their supply of money which exacerbated economic downturns as the central bank’s hands were tied as the increased money supply would need to be backed by a commensurate measure of gold. This is what happened in the Great Depression era, where the gold standard was tested to its limits.

Countries faced massive economic pressure and calls for liquidity, which the gold standard was unable to accommodate. Slowly but surely, countries started dropping the gold standard to have better control over national monetary policies in the 1930s. The final blow to the gold standard came in the post World War II Bretton Woods Agreement, which established the US Dollar as the world’s primary reserve currency linked to gold, while the other countries were pegged to the dollar. This system lasted until 1971, when Richard Nixon announced that the United States of America would no longer exchange gold for US currency, ending the gold standard.

Let’s look at gold's % of global international reserves. It has fallen since World War 2, however there is a rising indication of de-dollarization. Trust in the dollar is eroding due to the freezing of $300 billion in Russian assets since the Ukraine war in 2022 and the US's spiraling public debt and persistent inflation. Central banks are now buying record amounts of gold, driving up its price further.

Despite its discontinuation, the debate over the gold standard continues, with some parties believing it to be a symbol of fiscal discipline while for others it is an outdated system with severe restrictions.

Gold as a hedge against inflation

“When everything else is going down the tubes, gold is the one thing that’s likely going to do well. Home insurance also has a high return when you have a fire.”

William Bernstein, The Four Pillars of Investing

The 1970s was marked by numerous incidents of economic turmoil, characterised by sky high inflation rates. During this time the price of gold soared from 35$ per ounce to over 800$ per ounce at its peak in 1980. This dramatic rise in the price of gold during one of the most tumultuous times in history is why gold is said to be a hedge against inflation.

Even in the recent financial crisis of 2008, when we take a look at how gold performed against the NIFTY 50, we see that gold performed really well. As stock prices plummeted, investors turned to gold to protect their assets, driving its price higher.

During periods of geopolitical uncertainty, such as the Israel-Iran conflict wreaking havoc on markets , gold often becomes a preferred investment. Its status as a safe haven is especially valuable when markets experience heightened volatility, offering investors a reliable store of value amidst global instability.

But how did the recent pandemic period fare?

When examining cumulative returns from January 1, 2020, to December 31, 2020, gold emerged as the winner once again, delivering returns of approximately 24.59%. Meanwhile, the NIFTY 50, despite experiencing significant lows, managed to recover and delivered a return of 14.9% by the end of the year.

What about Cryptocurrencies?

Cryptocurrencies, particularly Bitcoin, were initially heralded as the modern-day replacement for gold. This claim stemmed from their limited supply, with Bitcoin capped at 21 million coins, compared to gold, which can always be mined further albeit at increasing costs and decreasing yields. This finite nature of cryptocurrencies was perceived as a robust hedge against inflation, much like gold traditionally has been.

The decentralised and digital nature of cryptos added to their appeal.

However, reality unfolded differently. Despite the theoretical advantages, cryptocurrencies exhibit extreme volatility, regulatory uncertainties, and security concerns, which undermined their status as a stable store of value. The envisioned stability and inflation-hedging capabilities never held up, leading to a more cautious and scrutinised approach towards their adoption.

Gold for Diversification

Diversification is gold’s biggest selling point. It moves independently from other assets.

While I don’t invest in gold personally due to my risk tolerance and allocation preferences, I understand why some investors include it in their portfolios. Gold requires disciplined rebalancing because it can significantly lag behind the stock market at times.

Comparing gold to Bitcoin is also intriguing. Recent months have seen impressive flows into Bitcoin ETFs. Despite new highs in gold prices, the AUM for the largest gold ETF (GLD) is still one-third below its peak.

Gold is far less volatile than Bitcoin, so there’s room for both in the market. It will be interesting to see if Bitcoin's demand impacts gold's demand over time. Gold has been valued for thousands of years, whereas cryptocurrency is relatively new. While technology can rapidly change the landscape, betting against gold’s long history may be premature.

Analyzing Returns from Stocks & Gold for each Decade

From 1928 to 1970, gold increased by 1.4% per year, below the annual inflation rate of 2%. From 1971 to 2023, gold's annual return was 7.9%, trailing the S&P 500's 10.8% annual return. However, the correlation of annual returns was -0.2, indicating solid diversification benefits.

Context is crucial for post-1970 returns. In the 1970s, gold rose nearly 1,300%, with a nine-year annual return of 33.8%. Some view this as gold being an excellent inflation hedge during that decade, while others see it as a correction from government-imposed price suppression in previous decades.

From 1980 to 2023, gold's annual return was 3.2%, lagging behind stocks (11.7%), bonds (6.5%), and cash (4.0%). The annual inflation rate was 3.2% during this period, resulting in a real return of zero for gold. This challenges the notion of gold as an inflation hedge.

Despite its long-term performance, gold has offered valuable diversification at times. During the 2000-2009 "lost decade," the S&P 500 declined by 1% per year, while gold rose over 14% annually. From 2000 to 2023, gold's annual return was 8.5%, compared to the S&P 500's 7.0%. Since the Great Financial Crisis, from 2009 to 2023, gold's annual return was 6.0%, whereas the S&P 500 returned 13.8%.

Thus, the case for gold varies based on the timeframe. Long-term, gold offers no cash flows, dividends, or earnings, yet it has been valued for thousands of years, which is significant. Its diversification benefits are evident when examining annual returns by decade.

The relationship between gold and stock prices

The inverse relationship between gold and stocks is a well-documented phenomenon in finance where the price of gold tends to rise when stock markets decline, and vice versa. This dynamic is driven by investor behaviour and market sentiment: during periods of economic uncertainty or market volatility, investors seek the safety of gold as a "safe haven" asset, increasing its demand and price. Conversely, in times of economic growth and market stability, investors prefer the potential higher returns from stocks, leading to a decrease in gold prices as funds are reallocated. This interplay reflects broader principles of risk aversion, opportunity cost, and asset diversification, highlighting gold's role as a hedge against stock market fluctuations.

When Gold & Stocks Rise or Fall Together

In March of this year gold futures on Comex hit a record high settlement price of $2,185.50 an ounce, marking the sixth consecutive record finish.

Similarly, Bitcoin reached a new high of over $70,000, and the S&P 500 and Nasdaq Composite also set record closes.

The expectations of the Federal Reserve cutting interest rates contributes to rising valuations across, gold, stocks, and real estate. Additionally, the prospect of a weakening U.S. dollar and rising geopolitical tensions further bolster gold prices.

Bitcoin's rise is driven by similar factors such as the anticipated Fed interest rate cuts, the weakening dollar, and geopolitical tensions. The approval of Bitcoin ETFs has made it more accessible for investors, further boosting its value.

‘We are living in an attention economy, and bitcoin gets more attention than gold.’

— Alex Pickard, Research Affiliates

Alex Pickard believes that Bitcoin's greater media attention in the "attention economy" is driving more investors towards it, potentially luring them away from gold. While it may not be entirely accurate to say that Bitcoin consistently draws investors from gold, it is undeniable that Bitcoin has maintained a consistent presence in the media.

Gold prices are driven up by supply constraints from mining challenges and strong demand in jewellery, technology, and central bank reserves. Bitcoin prices increase due to its fixed supply cap and growing demand from investors and institutions, bolstered by its perception as a hedge against financial volatility. Both assets benefit from low interest rates and economic uncertainties.

Is Gold At a Multi Year Bull Cycle?

Let's break down recent developments in gold prices. Technically, gold has broken out of a multi-year consolidation phase, signaling the start of a potential multi-year bull market.

Long-term fundamental indicators also show that gold is undervalued, particularly with declining trust in credit. Historically, during periods of low trust in credit, such as World War II and the late 1970s, gold's value relative to financial assets ranged between 7% and 10%. Currently, it's at 3%, indicating significant potential for growth. We should also consider the value of US monetary gold relative to the broad money supply (M2). The ratio is rising from near historic lows, similar to periods in 1971 and 2000 that preceded multi-year gold bull markets. This suggests another bull market could be beginning.

Additionally, the dollar's status as the world reserve currency is declining, which further supports a bullish outlook for gold when compared to credit in the form of foreign exchange.

Let's compare the US equity market size to the economy (GDP) over the past 120 years. Equity can be viewed as a form of perpetual debt. The data shows cycles of easy money and credit inflating equity bubbles, followed by currency debasement, which results in higher gold prices. The chart below illustrates the US equity market capitalization to GDP and the dollar gold price, suggesting a strategy of being overweight in gold.

These cycles typically unfold as follows: when a bubble bursts, central banks ease monetary policy to stimulate the economy. Often, this overshoots and sets the stage for the next bubble. Fiat currency fuels these bubbles, leading to a cycle of bubbles and increasingly easier money. This pattern causes the currency's value to decline and the gold price to rise, resembling Exter’s pyramid where credit expands and the gold price increases. Currently, the equity market relative to GDP is likely near its peak, indicating a potential significant rise in gold prices in the coming years.

Practical Investment Options for Gold

Investors looking to diversify their portfolios can choose from several gold investment vehicles, each with its own set of benefits and considerations. Physical gold, which includes coins, bars, and jewellery, requires careful consideration of storage and insurance costs, as well as potential challenges in liquidity when it's time to sell. Gold Exchange-Traded Funds (ETFs) offer a more liquid option , allowing investors to buy and sell shares that represent gold just as they would trade stocks, without the direct burden of storing physical gold. For those interested in the gold industry rather than direct gold ownership, gold mutual funds invest in the stocks of companies that mine and refine gold, though these funds don't track the price of gold directly, they are influenced by the gold market's dynamics. Digital gold is another modern option, providing the ability to purchase gold online with secure third-party storage, simplifying the logistics of ownership.

Here is a list of the top 10 mutual fund houses for you to select.

When considering gold as an investment, it's important to account for factors such as the associated costs—like premiums above the spot price, storage fees, and insurance—as well as liquidity, which can vary significantly between physical gold and gold securities like ETFs. Investors should also think about how much gold to include in their portfolio; this often depends on one's risk aversion and economic outlook. Gold is typically favoured by risk-averse investors for its properties as an inflation hedge and a safe haven during economic instability. Financial advisors often recommend a gold allocation of about 5% to 15% of the portfolio, depending on individual risk profiles and market conditions.

Conclusion

The case for including gold in an investment portfolio is strong, thanks to its historical role as a store of value and a hedge against inflation, as well as its ability to diversify investment risks. Gold's intrinsic value and performance during periods of economic uncertainty have solidified its status as a safe haven asset.

In light of current global economic challenges such as inflation and market volatility, the relevance of gold in an investment strategy remains significant. While it does not yield income like bonds or stocks, gold can be a crucial component for those looking to reduce risk and preserve capital in their investment portfolio, making it an attractive option for safeguarding wealth.

Here are a few articles on Gold

1. How to Invest in Gold? Guide for Investors

2. How to Trade in Gold in 6 Simple Steps

3. Is Buying Gold a Good Investment - 10 Reasons to Invest

4. Should You Add Gold To Your Portfolio This Diwali?