Author: John Wang, Graphics: Elizabeth Roboz
The BRB Bottomline
A recent fall in the price of gold is causing many investors to be concerned. While the drop may seem scary on the surface, it shouldn’t present much to worry about in the long run.
The Basics of Gold
People have invested in gold and trusted it as a store of value ever since it was discovered over 5000 years ago. It’s the oldest form of currency used for international trade, dating back to the Egyptians in 1500 B.C, and for good reason. Gold always has substantial value and is easily liquidated. It’s a rare metal that’s difficult to obtain, and thus holds an intrinsic, built-in value. In a modern day context, it’s inflation proof and acts as an inflation hedge—it preserves its real, rather than nominal value in an intertemporal situation.
Gold is straightforward and intuitive, unlike alternative currencies and investing options available in the modern-day such as cryptocurrencies or non-fungible tokens (NFT). It’s an investment that can be visualized in the form of a physical, tangible object. Because of this, according to psychiatrist Dale Archer, gold offers comfort and a semblance of stability in the midst of instability. Psychologically, people feel more confident and put more faith in an investment when they have something tangible in front of them to back the investment, instead of just an abstract concept such as a government promise or a digital address. Gold has been used for more than 5000 years, and it is going to be used for more than 5000 more. It’s always been a reliable investment that gains nominal value at the rate of inflation, and there’s no reason to believe it will not continue to do so in the future. It’s a great way to diversify a portfolio, serving as a sort of stabilizer to smooth its rate of return.
Traditionally, diversification of a portfolio comes in the form of buying many different stocks from separate and ideally unrelated industries. Investing in gold allows for an even safer diversification of portfolios, since the price of gold is inversely proportional to the stock market. Therefore, investing in gold is regarded as a very safe strategy that can serve as a complete hedge against dips in the stock market, dips that could otherwise cripple an investing portfolio. Thus, gold is not just an investment that can yield high returns, it’s also a versatile shield that can act as a safeguard in two different ways, against both inflation and stock market crashes.
As of recently, investing in gold has become digitized. Investors now have the option to invest in a Gold Exchange Traded Fund (ETF). These ETFs quickly gained traction over the last couple of years, now accounting for a significant part of the gold market and rapidly gaining popularity among both retail and institutional investors. Rather than being based in physical gold itself, Gold ETFs invest in assets that are backed by physical gold, and therefore offer most of the benefits that gold does, and then some. Just like physical gold, Gold ETFs also offer a hedge against inflation and stock market crashes.
Furthermore, investors who are concerned about factors such as storage, theft, and ease of transaction often pivot to Gold ETFs over buying physical gold. Physical gold needs space to be stored and has an inherent threat of being stolen. Furthermore, buying Gold ETFs is much simpler and has a very small minimum purchase of one unit, or the equivalent of just one gram of gold. It can be done any time online and without any entry or exit fee.
On the flip side of things, selling Gold ETFs is also much easier than selling physical gold. In addition to the transport costs of moving gold, it’s often difficult to find an instant buyer who is willing to purchase large amounts of gold for market price, no questions asked. Gold ETFs on the other hand can be sold at its market price instantly. Because of these factors, investing in Gold ETFs is an extremely appealing option, especially for newer investors who want to test the waters with gold-related investments and do not want to pay an arm and a leg just to enter the market for gold. Technological advancements in the realm of investing have allowed for gold to become an even more attractive investment.
But, investing in gold does present one major downside: it’s volatile. For decades, economists have explored the price of gold and researched factors that cause it to rise and fall. However, they ultimately disagree and have not come to a consensus about what definitively changes it. Here’s what we do know: the price of gold is fundamentally dictated by the basic market forces of supply and demand. The supply of gold doesn’t change much from year to year, so market demand has huge influence on the price. Specifically, as demand increases, the price of gold increases as well. This happens regardless of factors such as economic conditions and monetary policy. Other factors, such as unemployment rate and GDP, can have a contributing impact on price as well. Economics generally agree on the driving forces that affect the price of gold, but have differing opinions on the magnitude of their impacts. These driving forces include the Fed’s monetary policy, inflation rates, and social trends. The important takeaway here is that the price of gold can rise or drop at any given time, from an array of possible occurrences—even the most miniscule and inconsequential events.
So, there’s an apparent paradox: how can the price of gold be so volatile, changing based on the smallest fluctuations in the environment, and be stable at the same time? The solution to this paradox can be understood with the help of concepts in basic statistics.
A Slight Detour in Statistics
Every student in Statistics 101 has probably heard of the concept “regression to the mean.” They understand that the phrase refers to the “rule” that states that as the number of trials of an experiment increases, the mean of the trials will tend to the expected value. In layman’s terms, data tends to even out as more instances are collected. However, the idea that regression to the mean is a “rule,” or “property” found in statistics is flawed. There’s a similar analogy that can be found in physics. In physics, entropy is the amount of disorder found in a system.
Physics students are taught early on that all things in the physical world tend towards stability. But, is that really an observed “property” that is followed by all physical objects? Any physical object can either be in two states: stable or unstable. If it is stable, it stays that way, because of the definition of stability; if it is unstable, its position changes to another state that is either stable or unstable. This logic repeats itself until all physical objects are in a position of stability. Thus, the notion that things tend to stability is less of an attribute, or characteristic of physical objects, and more of a byproduct of the definition of stable versus unstable.
The same can be said about regression to the mean. With any observation, there will be random variation caused by factors in the environment. Some variation will drive the observation below its expected value, while others will drive it above its expected value. As long as the distribution of the errors is symmetric, over time, these random variations will cancel each out, and over a large number of trials, the average of the observed trials will stabilize around the expected mean. There is no special “property” that magically makes it so that if one observation is far away from the norm, the next observation is bound to be closer. The concept of regression to the mean is simply a “statistical artifact”—with that being said, it is not the result of an external rule that is being followed but rather a result of random variation.
The Link Between Regression and Gold
The price of gold is obviously not the result of a random experiment, but the same statistical concepts can be used to explain its behavior. Given the simplification that the price of gold can be expressed as some mysterious multivariate function with many different inputs, the price of gold can be modelled using a regression model of that unknown function. Because there will be some random error represented by a random variable, that regression model is not going to be perfect and there will be many points that do not lie on the function.
This is obviously a vastly oversimplified way to view the price of gold—as following a simple function that spits out a definitive answer based on given inputs. But the fact remains the same: in the short run, there will be extreme volatility caused by errors with high variance; in the long run, there will be increased stability as random variation takes its course. It’s important to note that obviously, regression to the mean doesn’t mean that if gold goes down initially, it is “due,” or “bound” by a mysterious statistical force in the ether to rise back up. It means that as the time horizon increases—and the wider it is, the more this will be true—the trend of gold prices will stabilize towards a smoother increasing graph as natural variations organically cause the trend to regress back to its theoretical model.
Recent Developments
In the past month, investors have been scared by a sudden dip in gold prices. In the 3rd quarter of 2021, global demand for gold fell to its lowest point since the 4th quarter of 2020. Consistent with Claude Erb and Campbell Harvey’s findings on the relationship between gold prices and demand, the prices also took a similarly large dip in late September to $1719.24 US Dollars per ounce—the second lowest point thus far in 2021 (the first on being March 3rd, its price being $1699.08 USD per ounce).
However, in the long run, gold is notoriously resistant to market fluctuations and psychological effects. Take, for example, when COVID-19 hit: at first, the price of gold dropped all the way down from $1700.17 USD per ounce on February 27th, 2020 to $1497.82 USD per ounce less than 10 days later. Then, it rebounded back up a month later, reaching the price of $1700 USD per ounce once again, before continuing to rise and eventually hitting the price of $1758 USD per ounce within another month. Or, take the situation of the 2008 financial crisis: the price of gold dipped rapidly within one month from $889 to $732 USD per ounce from September to October 2008. Then, it rose right back up in the next two months, hitting $889 USD per ounce once again, before continuing to rise even more. In both cases: COVID-19 and the 2008 financial crisis, the market of gold rebounded much faster than other markets did. In fact, they rebounded while many other markets were still crashing.
While the initial downfall of the price of gold is large and may seem scary, gold is an extremely resilient and robust investment. In the long run, the trend of the price of gold will be an increasing pattern. The graph of the price of gold over time can be used as a sanity check to verify that it does indeed regress to the mean over the long run. The more zoomed in the graph is, the more random and chaotic the price of gold will seem; as the graph zooms out, those rises and falls will “smooth out” and “fade away,” showing the bigger picture.
Despite its constant rises and falls over the short run, over a longer period of time, those rises and falls will become inconsequential. The most recent dip in gold prices might induce a psychological response to freak out and lose faith in gold investments, but there is no reason to panic: gold is, and will always be, a reliable investment over the long run, as long as the investor is level-headed and does not respond to random variation in the short run.
Take-Home Points
- Gold has long been a popular investing tool, and for good reason. It can make investors a pretty penny, and also serve as a shield for them that protects against inflation and stock volatility.
- The correct statistical concept of regression to the mean, not the misconstrued one, serves as an explanation for why Gold is so volatile in a narrow time horizon and so stable in a wider one.
- Recently, gold prices and demand have dipped to relative lows.
- Ultimately, gold should not be used as a short-term get rich quick scheme, but as a long-term stable growth tool.
- If it’s treated as a long-term investment, drops in its price and demand, even drops as extreme as the recent ones, should not be a cause for concern.