What Are We Buying When We Buy Gold?

In 1992, a Suffolk farmer stumbled upon the largest cache of Roman coins ever found. Unwittingly, he had uncovered a story of crisis and flight to safety as Saxons invaded and a Roman family buried their gold. This, the Hoxne Hoard, would lie undiscovered – but still precious – for 1,600 years. The family never got to use their safe-haven asset.

In modern times, gold is at the centre of fierce debate. Warren Buffett dismisses it as an asset that “only increases if the ranks of the fearful grow”. Ray Dalio counters that gold is “under-owned”, particularly at a time when we are losing a currency regime.

So, is gold a loss-maker in real terms, a store of value or even a value generator? Of course, the answer is more nuanced. Understanding gold requires us to examine three questions: why investors buy it, why its price behaves so strangely, and whether its scarcity will endure.

Three classic reasons to own gold

1. Inflation

In Nebuchadnezzar's time, an ounce of gold would buy 350 loaves of bread at roughly US$7.90 each (adjusted for today’s currency) – about the same price as a loaf from an artisan bakery today. Millennia later, gold commands similar purchasing power, acting as a powerful inflation hedge.

But timelines matter. Over horizons shorter than 20 years, gold proves unreliable, with volatility to rival the S&P 500. Only over long periods has gold historically maintained its purchasing power. Thus, for investors with very-long horizons, it may hedge inflation, but for shorter timeframes, it's a gamble.

2. Diversification

Gold is a diversifier to equities – with a compelling track record. It has historically outperformed many alternatives for portfolio protection and the yellow metal’s 10-year correlation with stocks is near zero on average. But this relationship isn't constant. Over time horizons of less than a decade, correlations can turn positive, and the benefits may evaporate when you need them most.

3. Crisis hedge

During the last 11 equity drawdowns, gold delivered positive returns in eight. Even when it fell, it declined far less than equities. Unlike expensive put options, gold can generate positive returns in both crisis and non-crisis environments.

Inelastic bands

As may be clear from the above, the long-term price of gold appears inelastic. A ‘golden constant’ exists, i.e., gold seems to be a continuous store of value over the long term.

Why is this? Mining gold is difficult, expensive, and geographically dispersed. Globally, no-one controls the output, with China, the largest producer, accounting for just 12.5% of mining.

Annual production is just 3,300 tonnes. As such, the total amount of gold ever mined is miniscule compared to other precious commodities, such as silver. It fits into a 23-meter cube – roughly the size of an Olympic swimming pool – and supply barely responds to price changes.

However, this inelasticity creates wild short-term price swings driven almost entirely by demand. And understanding this should at least inform the decision to invest in gold in the short-to-medium term.

The real price of gold is somewhat akin to a price-to-earnings (P/E) ratio. When the P/E is very high, expected returns on stocks are low because we expect some reversion. Similarly, given that the real price of gold has been relatively constant over the very long run, if the real price of gold is high, we expect some reversion.

Today, gold is also expensive relative to crude oil, silver, and copper. Historical patterns suggest low or even negative real returns over the next decade. While it’s important to remember that structural demand from de-dollarisation and potential regulatory changes could support prices longer than history suggests, investors buying at current levels are likely paying for safety and optionality, not growth.

The constant may not be sacred

What is more, the golden constant is not sacrosanct. In 2004, the introduction of gold ETFs meant retail and institutional investors could access gold more easily. This satisfied pent-up demand and created a structural shift in gold’s price level or constant.

Recently, this relationship changed again. The People's Bank of China now leads global purchases, driven by dollar weaponisation fears after the US closed SWIFT to Russian banks in 2022. China has established bilateral swap lines to reduce dollar dependence. Reserves are being diversified, and gold is at the top of the list.

And we might have more change in store. Basel III regulations may provide another catalyst. A 3% allocation to gold for banks’ High Quality Liquid Assets would provide a demand shock similar to what happened with the introduction of gold ETFs.

And what about threats to gold’s scarcity? Two main threats have emerged. Near-Earth asteroid 1986 DA contains an estimated 100,000 tonnes of gold worth US$10 trillion (at market prices). It's small (2.3 km) and requires no more fuel to reach than the Moon. Companies like AstroForge are already planning missions, while smaller, closer asteroids like 4660 Nereus offer even easier targets.

Secondly, nuclear alchemy is underway. Scientists transmuted bismuth to gold in 1980, albeit in microscopic quantities. Mercury, gold's closest atomic neighbour, is cheap and abundant. As nuclear fusion technology advances, large-scale transmutation may become theoretically possible.

Should one of these succeed, gold's scarcity premium may reduce.

The golden ratio

Gold is expensive today, making it unlikely to be a high-return asset over the next few years. Long-term threats to its scarcity are real. Yet in a world of US$38 trillion US debt, weaponised currencies, and eroding trust, gold offers something rare: an asset no government controls and no central bank can print.

Gold may have lower expected returns going forward but could potentially serve as an insurance policy. The Romans who buried the Hoxne Hoard understood this (although it didn’t stop them from losing their lives!).

This article was inspired by a discussion led by Professor Cam Harvey at the Man Alternative Investing Symposium. The discussion is based on two recent papers: Understanding Gold as well as Gold and Bitcoin .

This material is for informational and educational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy or investment product.