The many ways gold is misunderstood

For one of the earliest forms of currency known to mankind, gold is still highly misunderstood. In part, that’s due to the terminology used to describe its behaviour. Take a change in the gold price: this surely means that from one day to the next the metal must rise or fall in price.

But there is an illusion at play here, the same as when two cars are parked side by side and one car reverses while the other stands still. Passengers in the stationary car momentarily feel like their car is moving forward. Investors may not realise that when they hold gold, they are sitting in the stationary car. It is the “cars” to their left and right that are moving. Those “cars” could be fiat currencies (for example, the US dollar), real estate, equities, bonds, soft commodities, energy (like oil and coal), base metals (copper or nickel), bulk metals (iron ore), or other precious metals like silver and platinum.

It is these “cars” that are either moving forwards or backwards, gaining or losing consumption value, rather than gold. Any gold used in fabrication – like jewellery – is fully recovered for use repeatedly, into perpetuity. All the gold that has ever been mined is still in circulation. There is no other asset class you can say that about. So, an ounce of gold that was mined 1,000 years ago is still doing the rounds today and will be used again in some form or another for thousands of years to come.

That is, it will store value either as a bar, a piece of jewellery, a high-fidelity electricity conductor or even a tooth filling. In this vein, gold is the ultimate store of value against which investors assume risk when they veer into other “cars”, being asset classes.

Investors that get out of the stationary car (gold) into any one of the moving cars (equity) are taking the risk that the asset class will more than compensate them for leaving the safety of a stationary vehicle. Gold is therefore a true risk-free asset that, while you should not expect to be paid for holding it, prevents you from losing your shirt (the value of your capital), which is possible in other asset classes.

A planetary analogy

To extend the analogy, gold is like the sun in that it is the centre around which all other planets revolve.

Yet it is as common to hear investors say the gold price has rallied or plummeted as it is to hear people say the sun has risen or set. The correct terminology is that the US dollar, for instance, has weakened or strengthened, making an ounce of gold less or more affordable, respectively.

This terminology is important so that you can act when the US dollar has weakened (sell gold to buy the US dollar) or when the US dollar has strengthened (sell the US dollar to buy gold).

Since an ounce never changes in quantity but the dollar changes in value, a weak dollar buys you fewer ounces of gold. That is, you pay more dollars for an ounce, hence the misnomer that the gold price has risen, while a strong dollar buys you more ounces of gold (you pay fewer dollars for an ounce of gold), hence the misnomer that the gold price has fallen.

If your business is in property, then a weak property portfolio value means you must sell more of your property to afford an ounce of gold. The converse is true – a strong property portfolio value, relative to the price of gold, means you sell less of your property portfolio to afford an ounce of gold.

If your business is equities, a weak equity market means you must sell more of your portfolio (pay away more) to afford an ounce of gold, while a strong equity market means you must sell (pay away) less of your portfolio to afford an ounce of gold.

I’m sure you get the point.

Failure to identify which car is moving and which is stationary prevents you from maximising the ounces of gold you get when you sell the dollar, equities, bonds or real estate, and vice versa.

Store of value

The second miscomprehension is caused by investors using the terms “store of value” and “investment” interchangeably. While investments potentially possess value (intrinsic or extrinsic), none of them store value, let alone permanently. All investment assets are intended to grow (not store) value.

There is a lot of risk that resides in the space between growing and storing value. To continue the analogy of cars, if the car that represents the equity market moves forward, it is growing and gaining value. That could be via capital gains and dividends, income on bonds and preferred shares, and distributions from real estate investment trusts. The same car going in reverse means it is losing capital and income value.

This is the risk for which investors wish to be paid when they move out of storing value in gold into capital growth and income-yielding assets. That’s the distinction between an investment and a store of value. The former contains inherent risk for which an investor requires to be compensated, while the latter has no risk whatsoever and the holder requires no compensation.

By now, you’re probably asking yourself: if gold is an asset, but not an investment, and if the price you pay for an ounce of it is determined by the value of other asset classes that are often investments, what makes it a store of value?

Gold is a store of value because it, and it alone, possesses enduring qualities that mitigate against the risks associated with investing in all other classes combined.

Here’s how:

• While soft commodities spoil (and lose value) if not stored correctly, gold does not.
• While base metals oxidise to rust (if not stored correctly), gold does not.
• While equities and bonds can go bankrupt (and lose value), gold does not.
• While fiat money is often debased by an expansion of money supply through excess credit creation, the gold industry struggles (despite its best efforts) to increase mined gold production by more than 1%-1.5% in any given year.
• While the cost of transporting other commodities is a significant portion of their market value (15%-30%), the cost of transporting gold is negligible (less than half a percent) due to the high value of gold relative to its density.
• And while most commodities are impossible to use in perpetuity, once recycled from its manufactured product, gold can be reused when recovered.

In fact, gold has nothing in common with other commodities.

The other misnomer is a commonly held view that gold only has a price but no value, when in fact commodities and paper money require human intervention to prevent or minimise inherent diminution of value.

Hlelo Giyose is the chief investment officer at First Avenue Investment Management. This article was first published by First Avenue Investment Management.  

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