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Gold indeed is a fascinating asset. This is the case due to the myriad forms of explanation you will hear if you ask an investor why gold has intrinsic value and why they think the price of gold is going to go up.

If you distill down the responses people will give you for why they buy gold, you arrive with essentially three value drivers:

  1. It is incredibly rare.
  2. It looks pretty.
  3. Others find it valuable (or will find in more valuable in the future than they do currently).

Reasons 1 and 2 confirm why gold is used in jewelry. If gold were simply rare and not beautiful, it would find little demand. This explains why you don't hear about people making bracelets or rings out of Iridium even though it is technically a rarer metal than gold.

If the jewelry demand sets a price floor, reasons 1 and 3 explain the "store of value" argument for owning gold, or essentially the thought behind it as an investment class. Many would argue that it serves as a better monetary base than fiat currency like that created by governments to permit transactions. Since gold has little industrial demand, one could look at gold as being an ideal hedge of inflation if investor perceptions about its intrinsic value stayed fixed and there was no new supply

The Problems With the Investment Argument

Theoretically, gold could serve as a brilliant store of value, especially if one was concerned about the future value of dollars, euros, yen etc. etc. Unfortunately there are two major shortfalls for gold:

1. Investor perceptions of intrinsic value of gold can vary

Just look at the way gold performed from January 2009 to 2010. The U.S. government has calculated CPI-based inflation at 2.3% for that time period, and yet gold went on to return around 25% that year. While the sign here is correct (positive inflation was met with a positive return in gold), the magnitudes were totally off.

While this may seem trivial, it's an excellent example why gold can be flawed in its stated role as a store of value. Implicit in this 25% return was some sort of changing perception in terms of the intrinsic value of gold, which punctures the argument necessary for gold to be a perfect store of value: that investor conceptions of intrinsic value stay relatively constant.

2. Gold Has Its Own Form of Inflation: Mining

The second part of the "store of value" argument is that the introduction of new gold in to the market is capped, unlike dollars or euros which can be added just by hitting print. While it is true that there is a fixed amount of gold on this earth (how much is a good question), one thing is for certain: there is gold added to the international market every year through mining.

The chart below shows annual global gold production in metric tonnes from 1900 to 2007 from the GOLDSHEET mining directory.

yearly
(Click to enlarge)

To a prospective gold investor, the slope on this chart is very unappealing in that it is positive. If we use the total mined stockpile of gold as of 2009 of 165,000 tonnes as a benchmark, this means that worldwide gold inflation might be approximated at 1.5% annually. In a current environment of 2-3% rates of inflation, gold doesn't stack up terribly well compared to the dollar in terms of inflation.

Conclusion

While the theoretical investment argument for gold makes a great deal of sense, the reality of the situation is that gold is not the investment many people likely imagine it to be. This being the case, prospective investors should respond with pause before making the jump in to gold that many investment advisors appear to be suggesting these days.

Source: The 3 Simple Reasons Gold Is Appealing and Its Problems as an Asset Class