Many people own a piece of gold jewelry or a gold coin. But there’s more to gold than being a beautiful and sought-after precious metal. As a financial instrument and asset, the unique qualities that gold possesses make it difficult to define in the financial world. This confusion makes it harder for investors to understand gold.
So, what type of asset is gold? Aswath Damodaran, Professor of Finance at the Stern School of Business, NYU, has classified four different investment categories:
- Cash-generating assets
So where does gold fit in? When you invest in gold, what are you investing in?
Is gold a cash-generating asset?
Your cash-generating assets are investments that generate or are expected to generate cash flow. Examples of cash-generating assets include stocks, bonds, real estate, and some types of options.
Gold doesn’t generate cash like stocks (residual cash flow/dividends), bonds (contractually set cash flow), real estate (income from leasing/renting), or options (contingent cash flow). But gold has an ace up its sleeve.
Imagine inflation as a Pacman eating away at the purchasing power of the dollar and the assets that rely on it for value — dollar-denominated assets, such as stocks and bonds. Inflation is the reason that dollar-denominated assets need to yield and grow over the rate of inflation — faster than the Pacman can consume their purchasing power; otherwise, you’ll find you made a horrible investment — not in dollar terms as you have more dollars, but in real terms as these dollars are worth less.
But historically, gold, which is not a dollar-based instrument, rises with inflation. It doesn’t have to “work” harder and provide more dollars with decreasing purchasing power to escape the inflation Pacman. So gold is inflation-proof, but it is not a cash-generating asset.
Is gold a commodity?
Commodities derive value from their use as raw materials to meet fundamental needs. Common commodities include energy (oil), food (corn, soy), and metals (iron, copper).
Gold is a physical raw material just like a commodity. It has intrinsic value like a commodity (at least the cost to take it out of the ground and refine it). Do these attributes alone make gold a commodity? After all, gold is exchanged in the markets today as a commodity.
However, whereas commodities derive their value from their use, gold doesn’t have consumable properties. Gold lasts forever. If someone uses gold, it remains to be used again. You can’t say that about oil or corn. Once you use them, they are depleted. If you have a gold necklace, thousands of years later the gold will still exist and can be melted to create another piece of jewelry or a gold bar.
Only about 17.5% of the total demand for gold actually stems from its use as a raw material. The rest is held by investors in the form of jewelry, investment-grade gold products, etc. And because gold is never used up like oil or copper, all of the gold that has ever been mined is still with us.
This means that gold is traded as a commodity by the financial industry, but it doesn’t act like a commodity. To put this into perspective, right now, we have enough oil in storage to last us six to twelve months (worldwide). If oil production stops, so does our supply of oil. On the other hand, if gold mining stops, we don’t lose our supply. All gold ever mined is still here with us and will stay with us forever.
Putting aside logic, it’s important to see how central banks treat gold. Central banks own almost 20% of all gold ever mined. In their financials, they don’t treat gold as a commodity. They treat it as a 100% pure, non-discounted money reserve. Don’t be confused by people and financial writers who lump gold together with all commodities. Gold is not corn and doesn’t fit the bill as a commodity.
Is gold a currency?
A currency is defined by Professor Damodaran as a medium of exchange and a store of wealth that has a valued purchasing power. Professor Damoradan includes the dollar and the euro as currencies.
As I consider the definition of “currency,” I disagree with the esteemed professor on one issue. Is a currency automatically also a store of wealth and purchasing power? Well, it was, under the classic Gold Standard before 1933, where actual physical gold coins were in circulation. Even under the weaker Gold Standard post 1933, when the dollar was backed with gold and could be exchanged for it (only by world central banks and not by US citizens), it was a store of purchasing power. But when we’re talking about pure fiat currency (like the US dollar after 1971 and the discontinuation of the Gold Standard), I would argue that the dollar is not a store of purchasing power, or at least not a reliable store of wealth, as it is hemorrhaging purchasing power. The dollar is more a unit of unpaid obligation or a pure currency that serves as a medium of exchange.
Compare an ounce of gold, which you could have acquired for $35/oz in the 1970s, versus $35 in cash. If you purchased an ounce of gold in the 1970s and at the same time saved $35 in cash, the gold would be worth around $1,760 today compared to the $35 in cash. Gold shows it’s a store of wealth. The dollar is a medium of exchange, but its wealth is almost all gone after 50 years.
So, gold is not a currency, not really a commodity, and definitely not a cash-generating asset, could gold be a collectible?
Is gold a collectible?
Collectibles have no cash flow. They are not raw materials or methods of exchange. Their value is derived from aesthetic or emotional attachment ((think of the Mona Lisa or a baseball card of a player you adored as a child) as well as limited supply. Collectibles include trading cards and artwork.
Some people collect gold coins, so it’s easy to think of gold as a collectible. It’s true that some rare gold coins are collectible. Anything that is rare and sought after can be considered collectible, but that doesn’t mean that all gold is collectible.
For those who invest in gold, the aesthetic features of gold aren’t as important as its monetary function. The aesthetic features may not even matter to them at all. If you have a Mickey Mantle baseball card, you wouldn’t consider the paper it’s printed on to be a collectible; it’s just the material that the baseball card is printed on. The same holds true for a rare gold coin: It gets most of its value from its history and rarity, not the material it’s made of. But outside of these rare collectibles, the value of gold is in the gold and not what is on the face of the coin.
So, gold does not really fit any of Professor Damodaran’s categories. Gold has certain features that overlap with a few of these categories, but in reality gold is a unique asset.
Seeing gold as a unique asset
In the financial investment world, gold is a difficult asset to define. In normal times, people who are lulled into the Wall Street growth optimism believe what they are taught — the only way to beat inflation is to invest in assets that grow faster than the inflation rate (they can outrun the inflation Pacman). The emphasis on growth assets at all costs makes people who don’t understand gold disregard the precious metal until growth assets fail when times are tough. Only then do they learn that they need to have a portion of their portfolio allocated to offset inflation, stock market crashes, wars, and other crises.
JP Morgan said in a congressional testimony when asked about gold that “Gold is money.” By using gold as our money supply for over 5,000 years, humanity folded their store of wealth and their currency into one financial instrument. It was a great way of ensuring currencies maintained their purchasing power and held the rulers at the time accountable. But once the separation of gold and currency happened under Nixon in 1971 — the dollar is no longer a store of wealth but represents an obligation that is not backed by anything tangible — gold was left holding the role of a store of wealth.
Some governments want you to believe that their unbacked paper assets are a store of wealth. They want you to believe that the assets that are denominated in the dollar, like stocks and bonds, are stores of wealth and not speculative assets. But history begs to differ. Gold’s consistent rise in value over the last 50 years is showing the weakness of currencies. We need currencies, both paper and digital, as a method of exchange, but for long-term investments, look elsewhere.