Although most economists agree that gold is a safe-haven, Baur and Glover (2012) remind investors that the safe-haven features may change over time as gold gets more popular as an investment to protect against equity market. This is because investors who hold significant amounts of gold in their portfolios may be forced to sell some or all of these holdings in times of equity market stress when they face borrowing or liquidity constraints in other portfolio holdings.
This is an interesting point, especially when gold prices initially fell after Lehman Brothers’ bankruptcy due to forced sales (see chart 1), but we believe that the perception of gold as a safe-haven against crashes in any particular asset market is too limited. Gold is an insurance against broader systemic tail risks. The economic function of insurance is not to generate huge profits during normal times, but rather to protect investors’ wealth against unlikely but serious events (like house fires).
Similarly, from the fundamental point of view, gold is not purchased for yield when the economy functions well, but to protect wealth against tail risks (however, it is possible to reap decent profits from investing and trading in the yellow metal in all phases of the market cycle and the performance of signals from our Gold & Silver Trading Alerts proves it). From this perspective, it should be clear why gold has no yield. Has insurance any yield?
No, actually you have to pay premiums for being insured. The same applies to gold. And what are tail risks? Technically, they arise when the possibility that an investment will move more than three standard deviations from the mean is greater than what is shown by a normal distribution. To simplify, there are very unlikely events which entail very serious consequences. The best example is the last financial crisis. As you can see in the chart 1, stocks (and other standard financial assets) drastically fell after the Lehman bankruptcy and suffered huge losses in 2008, while gold ended that year with a modest gain.
Why are there tail risks and why does gold protects against them? It is in the very nature of our inherently unstable monetary system with its fractional reserve banking system, paper currencies and excessive credit, which is based only on faith. Gold used to be money for thousands for years, whereas our fiat money experiment has been here only since 1971. Thus, when this faith decreases, especially in the U.S. dollar, the unofficial world currency, gold prices rises. Contrary to paper currencies, gold is a real commodity which cannot be printed and has a certain use value, which sets a bottom for its prices – this explains why there is demand for it in times of distrust in the U.S. dollar system. You can think of gold as an insurance or backup in case of the collapse of the fiat money economy with the greenback as the world reserve currency.My view:
Let us think of gold as a giant thermometer.
What does a thermometer do? It measures temperature of its surroundings.
What does gold do? It measure the tail risk and fear associated with unstable fiat (faith based) currencies.
Now is a good time for some golden insurance!