Key Takeaways
- Unlike real estate, oil, or shares of corporations, gold has very little fundamental value on which to base a realistic price.
- The biggest use of gold is in making luxury items, with most of the yearly gold supply being made into jewelry (78%).
- People believe that gold is a good hedge against inflation, but there is no fundamental reason that its value should increase when the dollar falls.
- Most financial planners advise that gold comprise 10% or less of a well-diversified portfolio.
How a Gold Bubble Works
Gold bubbles are like any other financial bubble. When the price of gold shoots up beyond what its value is, it enters a bubble. Often, financial bubbles burst and prices plummet.
Unlike other investments, most of gold's value is not based on its contribution to society. People need housing to live in and oil for gas to drive their car, and the value of stocks is based on the profitability of the corporations represented.
On the other hand, thebiggest use of goldis as a commodity for the production of luxury items. Most of the yearly gold supply is made into jewelry (78%). Other industries, including electronics, medical, and dental, require about 12% of the year's supply. The rest is used for financial transactions (10%).
Sometimes with gold asset prices shape perceptions of an asset's value as much as fundamentals do. That can create a loop where an increase in price influences perceptions about the fundamentals. As prices go higher, so does investor confidence in fundamentals. These feedback loops can become self-perpetuating, and the bubble inflates until it becomes unsustainable. Prices spiral longer than anyone thinks they will, and the collapse is more devastating as a result.
More than any othercommodity, the price of gold rises mainly because people think it will. For example, people may believe that gold is a goodhedgeagainstinflation, and as a result, they buy it when inflation rises. There is no fundamental reason gold's value should increase when the dollar falls. It's simply because people believe it to be true.
Example of a Gold Bubble
Three years after gold hit a 2011 high of $1,896.50 per ounce, it fell by more than $800 per ounce by December 2015. Over the next two years gold prices had climbed to $1,300 an ounce because thedollar weakened. There was no inflation, and the stock market was setting new records. These are both historic drivers of rising gold prices. It was likely only the perception of possible inflation, due to thedollar's decline, that sent gold prices higher.
In 2020, the economy came to a standstill and, by August, gold prices had crossed $2,000 an ounce. By 2021, gold prices hovered between around $1,700 and $1,900 per ounce.
Why People Invest In Gold
Until the early 1970s, gold prices were based on thegold standard. TheBretton Woods Agreementmandated that gold was worth $35 per ounce. WhenPresident Richard Nixontook the U.S. off the gold standard, that relationship disappeared. Since then, investors have generally bought gold for one of three reasons:
- Tohedgeagainstinflation. Gold holds its value when the dollar declines.
- As a safe haven against economic uncertainty.
- To hedge againststock market crashes. A study done by researchers atTrinity College showsthat gold prices typically rise 15 days after a crash.
All three reasons were in play when gold reached a high price in 2011. Investors were concerned that Congress would not raise thedebt ceiling and that the U.S. woulddefault on its debt.
By 2012, much of this uncertainty was gone. Economic growth stabilized at a healthy rate of 2% to 2.5%, and in 2013, thestock market beat its prior recordset in 2007.
What It Means for You
Between 1979 and 2004, gold prices rarely rose above $500 per ounce. The rise to a then-record high in 2011 was a result of the worst recession since the Great Depression, and the 2020 highs were due to the recession.
Most financial planners advise that gold should comprise 2%-10% of awell-diversified portfolio. If you're holding more than that, talk to your financial advisor.
Frequently Asked Questions (FAQs)
Is gold in a bubble right now?
Bubbles are much easier to spot in hindsight than in the moment. Plenty of analysts try to determine when a bubble has formed or when one is about to pop, but it's almost always up for debate. One way to gauge the likelihood of an asset bubble is to use a long-term chart to analyze momentum indicators, such as the exponential moving average (EMA) and relative strength indicator (RSI). The longer those indicators remain at extremely bullish levels, the more likely an asset bubble becomes.
Why did the price of gold go down today?
As with other exchange-traded assets, the price of gold fluctuates every day at the whim of supply and demand market forces. The price may drop on a given day, simply because there were more gold sellers than gold buyers on the exchanges that day. Gold prices can also move as investors react to news elsewhere in the markets, like changes to interest rate policy.
