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Gold – the investment of the Pharaohs. The precious metal has been highly valued since antiquity for its rarity and lustre. For investors today, gold serves as a store of value and the “asset of last resort” in a diversified portfolio, as well as a nice touch to decorate an arm or a neck.

Gold has three basic functions: it’s a commodity, it’s a currency, and it’s an asset. Its main use, as the table below shows, is as a commodity: the raw material for jewelry and some electronic uses, notably connectors. As a currency, it’s considered the one currency that doesn’t have a central bank to mess it up – the supply is limited by the amount that can be dug out of the ground, not the amount that a high-speed printing press can create. It’s also seen as the one currency that will always be accepted in any circumstances, even if the global financial system collapses. And as an asset, it’s viewed as a “store of value” that will protect one’s assets from the predations of governments and business cycles.

The price of gold fluctuates continually during the day, much like the price of any other asset or commodity. The London Gold Fixing establishes a benchmark price twice each business day (10:30 AM and 3 PM, London time) in dollars, pounds and euros for pricing gold products and derivatives. China, the biggest producer, importer and consumer of the yellow metal, recently started up a twice-a-day gold fixing in Shanghai. That is denominated in yuan and so has yet to get much traction outside of the country.

The price of gold is affected by various factors, including:

Supply: Since it takes a long time to develop a gold mine, there is rarely a surprise increase in the gold supply. On the other hand, sometimes mines suffer from natural disasters or strikes that can disrupt the supply of gold.

Demand: The major use of gold is for jewelry, which means fashion plays a large part in determining supply. Of course one reason why people favor gold jewelry is as a store of value that they can wear. Gold demand tends to rise in the summer, the wedding season in India.

Demand for gold rises with inflation, at least in theory. Gold is popularly viewed as one of the best hedges against inflation, which is in effect the debasement of paper (fiat) currency. Gold is considered to be the one “currency” that does not have a central bank and so cannot be debased.

Gold does not pay any interest and so when real (i.e. after inflation) interest rates go up, demand for gold tends to fall. Looked at the other way, low interest rates reduce the opportunity cost of holding an asset that does not pay any interest and so gold demand tends to rise as interest rates fall. Similarly, gold tends not to do as well when stocks are doing well, as stocks pay dividends and therefore offer an income stream as well as the possibility of capital gain.

Gold is priced in dollars, but most of it is bought by people who do not earn money in dollars. The (dollar-denominated) price therefore tends to rise when the dollar weakens, because people in those countries can now afford to buy more, or fall when the dollar strengthens.

Finally, gold tends to do well when everything else is collapsing, because people feel that even if the world as we know it comes to an end and paper money becomes worthless, gold will still function as a medium of exchange. For example, during the panic following the collapse of Lehman Brothers in 2008, demand for physical gold rose so much that some banks even in such famous gold trading centers as Switzerland and Hong Kong ran out of gold.

Buying physical gold presents challenges for the individual investors, because a) you have to be sure that it’s really pure gold, b) it has to be stored somewhere secure, and c) you have to prove it’s real gold when you want to sell it. Many people therefore prefer to buy paper gold, that is, exchange-traded funds (ETFs) that invest in gold and hold gold on your behalf. These can be traded like stocks. There are also gold futures. The interplay between the ETFs, the futures and the cash market is complex.


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