What Is a Gold Bubble?

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, the biggest use of gold is 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 other commodity, the price of gold rises mainly because people think it will. For example, people may believe that gold is a good hedge against inflation, 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 the dollar 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 the dollar'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 the gold standard. The Bretton Woods Agreement mandated that gold was worth $35 per ounce. When President Richard Nixon took the U.S. off the gold standard, that relationship disappeared. Since then, investors have generally bought gold for one of three reasons:

• To hedge against inflation. Gold holds its value when the dollar declines.
• As a safe haven against economic uncertainty.
• To hedge against stock market crashes. A study done by researchers at Trinity College shows that 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 the debt ceiling and that the U.S. would default 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, the stock market beat its prior record set 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 a well-diversified portfolio. If you're holding more than that, talk to your financial advisor.

Frequently Asked Questions (FAQs)