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Why Invest in Gold?

by Jonathan Buhalis

Gold is Rare While many commodities have been experiencing bull markets for the past few years, most other rocks and minerals are plentiful. At a given price, the supply of copper, coal, or iron ore can be increased. With gold, higher prices certainly lead to increased mining activity, but those efforts may or may not yield additional production. Looking at global production over the recent past shows modest production increase, even with periods of rising gold prices.

Annual production of gold tells only part of the story, because gold is not consumed the way other commodities are. It is not burned to make power as coal is or converted to ethanol as corn is. Central banks and ETFs keep it in vaults. Private parties keep their jewelry and then go down to the pawnshop to hock it when times get rough. It is estimated that of all the gold ever mined, 85% of it remains, and it's estimated at 130,000 tons. Of that amount, 30,000 tons are held in central banks, and 96,000 tons are in jewelry. It is precisely because gold does not go away that it has lasting appeal as money. Given the numbers above, it is a money supply that only grows at 2% per year and thus maintains its value.

Demand is on the Rise Demand for gold is driven mostly by the jewelry market, central bank reserves, and investments. Consider jewelry. As the number of wealthy people in the world increases, demand for gold jewelry is predicted to rise. Central banks, on the other hand, were net sellers of gold from 1995 to 2001 -- and here is where we note the irony of the best financial minds selling gold when it was at a 30-year low in price. Since 2001, there has been speculation about Russia and China increasing their central bank gold reserves, but data is limited. On the investment front, ETFs including shares traded on NYSE and Amex, have made investing in gold much more accessible to individual investor. These funds and similar products available in foreign markets have helped increase demand for investment gold.

Gold Protects In a peaceful, stable, non-inflationary world, gold would be valuable, but it would likely under perform as an investment class. However, gold prices rise in times of war, unpredictability, and inflation. In the past five years, the world seems to have become less peaceful, with instability rising in key energy-producing regions.

Of course, no one can predict the future, and no one knows whether war, instability, or inflation will increase or decrease. Study after study has shown that a well-chosen portfolio of stocks has always been your best bet for long-term capital appreciation. Many of those same studies also show that gold returns are not correlated to stock market performance. Therefore, a 5%-10% position in gold in your holdings may soften the blow of the next bear market.

Bottom Line When thinking of the ones you love, give a gift that will love them back. Gold will last far beyond our time on Earth and will remain beautiful. A thousand years from now, people will likely still adorn themselves with gold. In the coming decades, the supply of gold will rise only slowly, and that will keep the metal precious. Demand will likely rise as billions of people increase their purchasing power and barriers to investing in gold are eliminated. Finally, the next time the stock market tumbles; a position in gold might just help you sleep through the cold winter nights.

Factors influencing the gold price This ancient Egyptian golden bowl was buried in the tomb of a pharaoh and today sits in the British Museum. Gold items were often buried with pharaohs to use in the after-life, because gold is free from corrosion or decay.

Today, like all investments and commodities, the price of gold is ultimately driven by supply and demand, including hoarding and dis-hoarding. Unlike most other commodities, hoarding and dis-hoarding plays a much bigger role in affecting the price. Given the huge quantity of above ground hoarded gold, compared to the annual production, the price of gold is mainly affected by changes in sentiment, rather than changes in annual production or gold jewelry demand.

Central banks and the International Monetary Fund play an important role in the gold price. At the end of 2004 central banks and official organisations held 19 percent of all above ground gold as official gold reserve. The Washington Agreement on Gold (WAG) which dates from September 1999, limits gold sales by its members (Europe, United States, Japan, Australia, Bank for International Settlements, and the International Monetary Fund) to less than 400 tons a year. European central banks, such as the Bank of England and Swiss National Bank, have been key sellers of gold over this period

In November 2005, Russia, Argentina, and South Africa expressed interest in increasing their gold holdings. Other than Russia, these are not viewed as significant central banks, but any move by Japan, China, or South Korea to do the same would be seen as significant. Currently the United States Federal Reserve has 11% of its assets in gold , whereas China holds approximately 1% in gold.

Although central banks do not generally announce gold purchases in advance, some such as Russia have expressed interest in growing their gold reserves again as of late 2005. In early 2006, China, which only holds 1.3% of its reserves in gold, announced that it was looking for ways to improve the returns on its official reserves. Many bulls took this as a thinly veiled signal that gold would play a larger role in China's reserves, but the best estimate amount remains near 1%.

Sentiment It used to be said that "Gold is the world's frightened bunny". Whenever crisis threatened, the demand for physical gold increased.

Bank failures When dollars were fully convertible into gold, both were regarded as money. However, most people preferred to carry around paper banknotes rather than the somewhat heavier and less divisible gold coins. If people feared their bank would fail, a bank run might have been the result. This is what happened in the USA during the Great Depression , leading President Roosevelt to declare a national emergency and to outlaw the holding of gold by US citizens.

Inflation Paper currencies pose a risk of being inflated, possibly to the point of hyperinflation. Historically, currencies have lost their value in this way over time. In times of inflation, people seek to protect their savings by purchasing liquid, tangible assets that are valued for some other purpose. Gold is in this respect a good candidate, since producing more is far more difficult than issuing new fiat currency, and its value does not rely on any particular government's health.

Low or Negative Real Interest Rates Gold has a long history of being an inflation-proof investment. During times of low or negative real interest rates, when significant inflation is present, investors seek the safe haven of gold to protect their capital. A prime example of this is the period of Stagflation that occurred during the 1970s and which led to an economic bubble forming in precious metals.

War, Invasion, Looting, Crisis In times of national crisis, people fear that their assets may be seized, and the currency may become worthless. They see gold as a solid asset, which will always buy food or transportation. Thus in times of great uncertainty, particularly when war is feared, the demand for gold rises.

Production According to the World Gold Council, annual gold production is around 3,100 tons. However, the effects of recycling (1100 tons) and producer hedging activities take the annual gold supply to around 4,300 tons.

Demand About 2,500 tons goes into jewelry or industrial/dental production, and around 900 tons goes to retail investors and exchange traded gold funds.

Supply and demand Some investors consider that supply and demand factors are less relevant than with other commodities since most of the gold ever mined is still above ground and available for sale at a price. However, supply and demand does play a role. According to the World Gold Council, gold demand has increased dramatically in the last couple of years. The increase came mainly from the launch of gold exchange traded funds, increased investor appetite, and from jewelry. Demand from the electronics industry is rising by over 10% a year, jewelry by around 20%, and industrial and dental by about 20%. India has a voracious appetite for the metal and Dubai has recently announced its intention of building the largest gold retail marketplace in the world there.

Reasons to Say Yes to Gold Ownership
  • The dollar is weak and getting weaker due to national economic policies, which don't appear to have an end.
  • Gold price appreciation makes up for lost interest, especially in a bull market.
  • The last four years are the beginning of a major bull move similar to the 70s when gold moved from $38 to over $800.
  • Central banks in several countries have stated their intent to increase their gold holdings instead of selling.
  • All gold funds are in a long term up trend with bullion, most recently setting new all-time highs.
  • The trend of commodity prices to increase is relative to gold price increases.
  • Worldwide gold production is not matching consumption. The price will go up with demand.
  • Most gold consumption is done in India and China and their demand is increasing with their increase in national wealth.
  • Several gold funds reached all-time highs in 2006 and are still trending upward.
  • The short position held by hedged gold funds is being methodically reduced.

U.S. government economic policies over the past decade have systematically projected the U.S. economy down a road with uncontrollable federal spending and uncontrollably increasing trade deficits. Both will cause the dollar to lose in international value and will increase the price of alternative investments, such as gold.

With the recent devaluation of many international currencies, the U.S. dollar was the international safe haven of last resort. We are seeing signs of this ending due to many financial factors, the most important one being a falling dollar.

There are over one trillion dollars ($1,500,000,000,000) of U.S. debt owned by foreigners, which could be repatriated under certain conditions. This could cause a major decline in the value of the dollar and a soaring gold price.

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Content by Jonathan Buhalis
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