The Real Reason why people flock to Gold

Amar Pandit , CFA , CFP

I asked a few investors the other day “What do you think is the real reason for the noise around gold during uncertain times? Why does everyone start to talk about it?” The answers varied from “Market is likely to go down or gold will go up because of fear or Gold is a storage of value” but there was no real clear answer on why this happens. I thought of writing my thoughts on what really happens, and I think you will find it fascinating.

The first concept to understand is what is Money. While you can use terms as a medium of exchange, a measure of value, a means of payment or a position of wealth (Forbes Richest People), the reality is that Money = Trust.

It means a Trust in the Government, Systems, and Institutions. The U.S. currency also includes the motto, “In God We Trust”. The stronger the trust, the stronger the currency (I am simplifying this part and not including all the technical details but at a conceptual level, this is absolutely true).

Money = Currency = Dollar or Rupee or Any Other Currency = Trust

One of the key things for this trust is the Guarantee of the Government to honour the Currency in your hand. If you look at a Rs.500 Note (or any denomination), there will be the following words “Guaranteed by the Central Government. I promise to pay the bearer the sum of Rupees five hundred and it’s signed by the RBI Governor”. You thus trust the Government, RBI, and the systems to honour the commitment made to you. Likewise, the dollar is essentially backed by the faith and trust in the US government. Otherwise any currency is merely a piece of paper without the faith and trust in the government, institutions, and systems.

When the faith in the government, institutions and systems are shaken, people go to the primitive form of money aka Gold. The evolution of gold has happened over thousands of years and stories of it have been passed on from generation to generation. I am sure you remember your grandmother having mentioned gold or keeping gold as her store of value. The point that I am making is that the story is still as strong. Gold as a store of value and currency has a real long- term track record of thousands of years. Though no country currently backs its currency with gold, many have in the past, including the US until 1971. Thus, the track record of gold along with the stories over thousands of years makes it the only option people can trust when the trust in the government, institutions and systems are shaken.

Thus, Money = Trust = Stories.

However, the value of gold is what people perceive the value to be. It is a function of demand and supply nothing else beyond it. There is no traditional valuation method of gold to say whether it is too expensive or cheap. I had written a previous column on gold and how the prices in India are impacted by the dollar rupee exchange rate beyond the movement in gold prices (because gold is priced in dollars).

The dollar on the other hand has a track record of less than 200 years. The first dollar bill was issued in 1862 so that makes the dollar bill 158 years old.

Another point to note is that in countries where there is hyperinflation, the value of the local currency gets completely eroded, as the prices of all goods increase. Take the case of Zimbabwe, where the peak inflation (in November 2008), was estimated to 79.6 billion %. Their bank notes ranged all the way from 10 dollars to 100 billion dollars (This is one time when everyone seemed to be a billionaire but none of them actually were). As I mentioned, the root cause of this is a lack of trust in the government, institutions and thus the currency.

The right questions to ask in uncertain periods then are (before rushing to gold):

  1. Is the US Dollar or your currency going to collapse and lose its value?
  2. Is the faith in the US government or your government and institutions going to be lost forever?
  3. Are we going to live in a world our ancestors lived thousands of years ago with gold as the dominant form of currency?

I personally do not think any of the above is likely to happen at least in our lifetime. Thus, do not just blindly rush to invest in gold without understanding the underlying nuances.

There will be times people will call gold a safe haven and there will be times when the dollar will be the preferred haven asset. Have a goal based financial plan that is planning driven and not one that is fear driven.