Given the risk/reward trade-off associated with any investment, it is important to acknowledge and understand not only opportunities, but also key risks.
Non-standard valuation: Gold does not directly conform to the most common valuation methodologies used for equities or bonds. Without a coupon or dividend, typical models based on discounted cash flows, expected earnings, or book-to-value ratios struggle to provide an appropriate assessment for gold’s underlying value. This presented an opportunity for the World Gold Council to develop a framework to better understand gold valuation.
Our gold valuation framework allows investors to understand the drivers of gold demand and supply and, based on market equilibrium, estimate their impact on price performance.
No cash flows: A widely perceived drawback of gold is that it does not provide any regular income, unlike other asset classes such as bonds, property or even some company stocks. But the reason for this is simple: gold has no credit risk. There is no promise to repay. Nor does it bear any counter-party risk. This means, however, that investors depend on price appreciation to benefit from gold. And in this regard gold has a good track record. It has generated long-term positive returns in both good and bad economic times. At the same time, gold has outperformed many other major asset classes over various investment horizons (3 years, 5 years, 10 years, 20 years, and 50 years). Gold’s strong performance is no coincidence: it is a by-product of the underlying demand and supply dynamics, which combine a natural scarcity with diverse sources of demand including jewellery, technology, investment and central banks.
Price volatility: Gold is a great diversifier to a portfolio because it behaves so differently to equities and bonds, not because it has a low volatility. And while gold is a less volatile asset than some equity indices, other commodities or alternatives, in some years the metal has posted close to 30% gains (2010) and in other years it has posted close to 30% losses (2013). On balance, however, gold has an asymmetric correlation profile with equities; in other words, it does much better when equities fall than it does badly when equities rise.
