Have you ever pondered the question, “Why Is Gold Valuable?” Throughout history, gold has held a unique position, transitioning from a symbol of affluence and authority to a form of currency and a reliable store of value. From ancient civilizations to modern economies, gold has been employed to signify status, project power, and facilitate international trade.
Yet, despite its alluring shine, gold’s intrinsic worth is a subject of debate. Beyond niche applications in electronics and dentistry, gold’s value in human society largely stems from its very nature – because it is gold, and not another substance. This explains why over 90% of the global gold demand annually is channeled into jewelry and investment, rather than industrial applications. We predominantly value gold for its inherent properties rather than its practical uses in conductivity or dental restoration.
But why gold specifically? Why not aluminum, iron, or any other element?
And, more importantly, what role does gold play as an investment today? Given gold’s recent price surge of 10% over the past six months (while benchmarks like the S&P 500 have remained relatively static), should you consider incorporating it into your investment portfolio? What are the compelling reasons for or against this?
This article aims to delve into these questions and provide comprehensive answers. Let’s begin by exploring the historical factors that propelled gold to become the most coveted metal in human history.
The Unique Properties of Gold: Scarcity, Durability, and Malleability
Unlike numerous other metals found across the globe, gold has consistently maintained its elevated status due to a combination of three distinctive characteristics: scarcity, durability, and malleability. Let’s examine each of these in detail.
Scarcity: Goldilocks of Metals
Gold’s allure would be diminished if it were as abundant as aluminum, the most prevalent metal in the Earth’s crust. Conversely, if it were as rare as rhodium, a scarce Earth metal with a production rate ten times lower than gold, its widespread use would be limited. As Warren Buffett astutely noted in his 2011 letter to shareholders:
Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.)
This existing gold reserve grows by only a few thousand metric tons annually, representing approximately 2% of the total global gold stock.
This balance between gold’s existing quantity and its annual production makes it the “Goldilocks” metal – sufficiently rare to be highly valued, yet accessible enough to be discovered and utilized across various regions worldwide. Without this relative scarcity, gold might have remained just another glistening rock.
Durability: Standing the Test of Time
Scarcity alone isn’t sufficient to bestow gold with its esteemed status. Gold possesses the remarkable quality of being among the most durable metals on Earth. It is resistant to rust and tarnish, and it only corrodes under very specific and uncommon conditions.
Gold’s inert nature means it can be buried and remain virtually unchanged even after millennia. Peter Bernstein highlighted this enduring quality in The Power of Gold:
In Cairo, you will find a tooth bridge made of gold for an Egyptian 4,500 years ago, its condition good enough to go into your mouth today.
This exceptional durability positions gold as a true store of value. Its resistance to degradation through everyday use is a primary reason why gold has served as currency throughout history.
In a world where decay is commonplace, gold’s ability to withstand the passage of time is a significant factor in its enduring value.
Malleability: Versatility and Utility
Even with its scarcity and durability, gold’s rise to global prominence would have been considerably more challenging without its unparalleled malleability. Gold is, in fact, the most malleable of all metals. Its remarkable flexibility allows a single ounce to be hammered into an incredibly thin sheet covering approximately 100 square feet or drawn into a wire stretching over 50 miles. Pure gold’s softness (relative to other metals) makes it easily reshaped.
Consider the practical advantages of this malleability for a store of value. Gold can be readily divided, concealed, and transported with minimal effort. These qualities are highly desirable in a material intended for trade and wealth storage.
Combined with its scarcity and near-indestructibility, gold’s malleability cemented its appeal, driving global exploration and acquisition for centuries. Beyond these physical attributes, gold’s inherent value is deeply rooted in the concept of “proof of work.”
Gold as Proof of Work: The Laborious Path to Acquisition
While gold’s beneficial chemical properties are significant, its true value is arguably derived from the inherent difficulty in obtaining it. As Joe Weisenthal articulated in a May 2018 speech:
One of the striking things about gold is just how incredibly hard it is to attain (and hold onto once you have it) and the different things you have to master to get gold.
To get gold you — Have to be good at warfare — Be able to marshall an extensive human workforce to mine it — Mastery of global supply and logistics routes — Be able to command guards who will watch your gold, and not steal it — Have the technical know-how to get gold out of the ground, which is expensive and cumbersome. And so on…
In other words, when you have gold you’re communicating all the different things you’re capable of (mastering supply routes, commanding an army, scientific endeavor, marshalling labor, etc.)
Gold, then, is a very specific proof of work. If you can get gold, you’ve proven that you have the ability to run a state or some state-like entity.
While acquiring gold today doesn’t necessitate “running a state-like entity,” the underlying principle remains valid. Historically and presently, gold’s value isn’t solely about possessing a rare, shiny metal. It’s about the implied message of that possession: demonstrating the skills, resources, and capabilities to acquire something rare and desirable.
The historical trajectory of aluminum provides a compelling illustration. Upon its initial discovery in the late 1700s, aluminum was actually more valuable than gold due to the extreme difficulty of its extraction. Notably, aluminum was used to cap the Washington Monument when it was completed in 1884, a testament to its perceived value at the time.
However, as aluminum refining processes advanced and extraction became more efficient, its rarity diminished. This increased availability reduced its “proof of work” and consequently, its value relative to gold declined. The metal once deemed worthy of adorning a national monument eventually became commonplace, used for everyday items like beverage cans.
This narrative underscores the power of “proof of work” in determining value. Scarcity born from difficulty of acquisition translates to admiration and desirability, while abundance leads to diminished perceived value. This principle is central to understanding gold’s enduring appeal.
Having explored gold’s societal value, let’s now consider its role as an investment and its potential value for individuals.
Gold as an Investment: From Currency to Portfolio Diversifier
Historically, gold functioned primarily as a form of currency. This stability is highlighted by William Bernstein’s observation that:
…an ounce of gold bought a fine men’s suit in the time of Shakespeare, and so it does today.
When gold served as money itself, there were no inherent investment gains to be realized from simply holding it.
This paradigm shifted after the United States severed the dollar’s direct link to gold in 1971 and subsequently permitted private gold ownership again in December 1974.
Since then, gold’s price has risen from approximately $156 per ounce to around $1,930 (as of January 2023). Even after accounting for inflation, gold has roughly doubled its purchasing power since its separation from the U.S. dollar.
However, gold’s appreciation has significantly lagged behind the inflation-adjusted growth of the S&P 500 (including dividends) from December 1974 to December 2022.
Over this period, the S&P 500 outperformed gold by a factor of 16 in real terms. This disparity might lead some to question the rationale for long-term gold investment. However, this perspective overlooks gold’s potential value within a diversified portfolio. Gold’s true investment merit often lies in its interaction with other asset classes.
Before exploring the portfolio benefits of gold, let’s identify the type of investor for whom gold may not be a suitable investment.
Who Should Steer Clear of Gold Investments?
Considering gold for long-term investment? Be prepared for potentially extended periods of underperformance and price declines, as illustrated by gold’s historical drawdowns:
If substantial drawdowns are a concern, you’re not alone. Many investors find it challenging to maintain conviction during prolonged periods of negative returns. Even with recent price gains, gold remains below its 2020 peak.
Furthermore, gold exhibits higher volatility relative to its returns compared to many other asset classes with similar risk profiles, such as equities and REITs. This is evident in a risk-versus-return comparison of various asset classes:
Gold appears to deviate from the typical “higher risk, higher reward” pattern.
Lastly, gold can experience decades of lackluster returns, which can test the patience of many investors. Decade-by-decade returns from 1975 to 2022 reveal periods of significant real losses for gold:
These factors might lead some investors to conclude that gold’s allure is not as strong as it initially appears.
However, these drawbacks are primarily based on gold’s individual performance, not its contribution to a broader portfolio. Therefore, if your investment strategy focuses on individual asset performance rather than overall portfolio outcomes, gold may not be an ideal choice.
But, if you adopt a portfolio-centric perspective, gold can potentially offer valuable diversification benefits. Let’s explore why.
Who Can Benefit from Investing in Gold?
While gold’s risk-reward profile as a standalone investment might deter many, its portfolio diversification properties offer compelling reasons for inclusion.
Consider a portfolio equally allocated to the S&P 500 (33.3%), long-term U.S. bonds (33.3%), and emerging market stocks (33.3%). Now, imagine reallocating to include gold, resulting in a 25% allocation to each: S&P 500 (25%), long-term U.S. bonds (25%), emerging market stocks (25%), and gold (25%).
Comparing the growth of these two portfolios from 2005 to January 2023, the portfolio incorporating gold would have outperformed the gold-free portfolio:
This outperformance was achieved while generally maintaining lower overall portfolio risk (standard deviation):
This demonstrates gold’s potential to enhance portfolio performance and reduce overall risk, even if its individual asset performance is less compelling.
Gold’s portfolio diversification benefits stem from its low correlation with traditional risky assets like stocks. The average correlation between monthly returns of gold and the S&P 500 is near zero, although this correlation has fluctuated historically:
Furthermore, gold can act as a portfolio stabilizer during periods of market stress. Consider gold’s performance relative to the S&P 500 during the COVID-19 market crash in March 2020:
While initially declining with equities, gold recovered and outperformed as stock markets continued to fall. In such turbulent times, gold can serve as a “mental life raft,” providing stability when other assets are declining.
However, it’s crucial to remember that gold’s outperformance in March 2020 occurred while it was still in a drawdown from its 2011 highs. Overcoming periods of underperformance is essential for long-term gold investors. If you can maintain a long-term perspective and appreciate gold’s diversification benefits, incorporating it into your portfolio may be worth considering.
The Takeaway: Value is Subjective
So, why is gold valuable? Is it due to its historical role as “proof of work”? Is it its unique chemical properties that propelled its prominence? Or is it its contemporary function as a portfolio diversifier?
Perhaps it’s a combination of all these factors, or none of them exclusively. The key insight is that value is ultimately subjective and determined by perception.
Some may view gold as an archaic relic favored by fringe groups, while others see it as a safe haven in an unstable financial world.
The reality likely resides somewhere in between. In an increasingly digital world with evolving forms of value storage, gold faces greater competition than ever before. However, dismissing a signal of “proof of work” that has endured for millennia might be premature.
Invest thoughtfully, considering your own perspective on value and risk. Thank you for reading.
