A beginner’s guide to gold: what’s it for?

We often talk about gold here at MoneyWeek magazine and in Money Morning.

It occurred to me the other day that some of you might wonder what on earth for.

It is, after all, not considered a mainstream asset class. (I'd say that it's more respectable than it was back in the early 2000s, when no one knew what it was for, but it's still unusual).

So why do we think that everyone should have a bit in their portfolios? What's gold for?

Read on.

Gold and asset allocation

Gold is a weird asset.

I like to keep things simple, and you should too. When I think about asset allocation, I divide the ideal portfolio into equities (shares); bonds (IOUs); property (basically a subset of equity but sufficiently different to pull out); cash; and gold.

Three of those are valued based on the income they will pay you over time. Cash in the bank, meanwhile, will pay you interest and gives you "optionality" the flexibility to act when opportunities arise.

But gold doesn't do anything. It doesn't pay an income. In fact, it costs you to hold it.

Yet, despite all that, gold has been used as a store of value for centuries. Why?

People will often argue: "Oh, gold only has a value because other people say it has." That's true. But I mean, that's true of anything it's a pretty facile statement.

What they're actually saying is: "Yeah, but instead of gold, you could have peacock feathers, or shiny shells, or magic beans."

Yet that's not true. If you want to find an object that can act as a store of value over a very long period of time, then there are actually few substitutes for gold.

Take a look down the periodic table. There are over 100 elements on there. Of them all, gold is the best suited to the job of "store of value".

You can't easily hold a gas or a liquid, so the elements that are in that condition at room temperature are out. And most other substances are too reactive most metals rust or tarnish, for example. A store of value is no use if it rots away over time.

Pretty quickly, you find that gold is the best substance for the job. It looks nice. It is pretty malleable for a metal. It is just rare enough to be valuable but not so rare as to be impractical to use as a medium of exchange. It's easily portable from one place to another.

And it doesn't decay every so often a keen metal detectorist will find a hoard of gold from a thousand-odd years ago, and it's worth pretty much the same (give or take) as it was back then.

In short, gold is valuable because human beings need a store of value and a medium of exchange ie, money and it happens to be the substance that fits the job description most neatly.

The other reason to hold gold is because it's not reliant on another party for its value.

Shares in a company are great unless the company goes bust. Bonds (IOUs) are fine unless the borrower doesn't pay you back. Cash in the bank is handy unless the currency collapses or the bank goes bust or both.

Land is wonderful and an ideal store of long-term value. But it's not very portable, and your ownership of it is ultimately only as good as the legal system that asserts your title, or your own ability to defend it from an individual or government that wants to take it away from you.

Gold is just gold. If you own gold coins, their value is not dictated by some other party.

Gold tends to do well when the outlook is gloomy

That's why we suggest you own some gold as part of your diversified portfolio (a very rough guide being 5%-10% although that depends on your circumstance).

As an asset, it behaves sufficiently differently to the other major asset classes to be worth holding in its own right. When the value of other assets is going down, gold will go up and vice versa, of course.

That said, there are times at which gold does come into its own. Gold tends to do best when "real" (after inflation) interest rates are falling, for example.

What does that mean? It means that the inflation rate is rising faster than interest rates can keep up. That can happen for a few reasons, and mostly indicates wider economic problems.

Inflation might be rising, and interest rates falling. This would generally be happening during "stagflation" an economy sufficiently weak for the central bank to be loosening monetary policy, combined with rising prices. This happened in the 1970s, for example.

Alternatively, inflation might be falling, but interest rates falling faster which would indicate a central bank trying to stave off a damaging deflationary period.

Or inflation might be rising, and interest rates rising more slowly which would indicate an economy in danger of overheating and a currency at risk of debasement.

Gold also tends to benefit when investors are worried more generally about solvency and counterparty risk within the financial system. Gold doesn't have a counterparty therefore it's attractive in a world where no one is sure who they can trust. (Which might be useful at a time when the future of the monetary system itself is up for debate something we'll be discussing at the MoneyWeek Wealth Summit.)

You can see why people often think of gold as an "apocalypse" asset. It does tend to do well when things look bleak, whereas most assets come into their own in sunnier climes. But that's the point of diversification we get rainy days as well as sunny days, so it's sensible to prepare for both.

In terms of buying gold, there are lots of options. You can buy physical gold in the form of bullion or coins and store it yourself. You'll probably need a safe, and you'll need to let your home insurance policy provider know. You can buy physical gold and have it stored for you.

Or you can get exposure to gold via a physically-backed exchange-traded fund (ETF). These are stock-exchange traded financial instruments that are backed by gold stored in vaults.

One point I would always make is that when we talk about gold, we mean gold specifically. Gold mining stocks can do well when the gold price is doing well, but when thinking of them as part of a portfolio, you should always consider them as part of your equity allocation, not your gold allocation.

Anyway so that's gold for you. If you have more questions after reading this, or you'd like me to cover a specific topic in a similar way in Money Morning, send me an email at editor@moneyweek.com with "beginner" in the subject line (it helps me to whittle them out of our overflowing inbox).