The following article was written by Darren who writes at his blog MoreThanFinances.com.
I never quite understood how gold works as an investment, and how it might fit as a part of one’s portfolio. Sometimes I’ll hear statements such as, “Now’s a great time to buy gold!” Or I’ll read in investing books that you should have a small percentage of your portfolio invested in gold or precious metals. This article will explain how to invest in gold and why you may or may not want to.
What exactly is it about gold, that we should consider having a percentage of it in our portfolio?
After doing some research at this site, I’ve found that there are five reasons why you might want to invest in gold.
- It provides a bit of safety - In volatile economic times, people may want to protect their investments by moving them into safer assets. Gold doesn’t rely on an borrower’s promise to pay, as in the case of a bond. This offers protection from default risk.
- To diversify - Diversification protects your portfolio from fluctuations in the value of a single asset, or a group of assets that usually move in a similar direction. Most portfolio’s are only invested in traditional assets such as stocks, bonds, and money market instruments. Therefore, portfolios that include gold are generally less volatile than those that do not.
- To protect against inflation – The purchasing power of many currencies has decreased over time due to the rising prices of goods and services. However, over the long term, gold has kept its purchasing power. It’s value has remained constant in terms of the real goods and services it can buy.
- To hedge against the dollar - Gold is often used as a hedge against the U.S. dollar. If the value of the dollar decreases relative to the other main currencies, then the price of gold will rise.
- To manage risk – Gold is a lot less volatile than most commodities and many equity indices such as the S&P 500. Including assets with lower volatility in your portfolio will reduce its overall risk.
So what determines the price of gold?
It’s one of the basic principles of economics – demand and supply. While demand has shown growth, there has not been much of an increase in production levels of gold.
Demand for gold comes from three main sources.
- Jewelry – This is probably the most obvious. Think of earrings, bracelets, necklaces, and everything else. This accounts for about two-thirds of gold demand.
- Investments – Since 2003, investment has accounted for the strongest source of growth in demand.
- Industrial uses – Believe it or not, a small amount of gold is used in electronics such as cell phones, calculators, and GPS units because of its resistance to corrosion. This accounts for about 11% of demand.
Supply for gold comes from four main sources.
- Mine production – Approximately 2,485 tonnes (or 2,485,000 kilograms) of gold are mined per year.
- Recycled gold - Gold is of such value that it is capable, if needed, of being extracted, melted down, refined, and reused.
- Central banks – They hold about one-fifth of the stocks of gold as reserve assets. Governments hold about 10% of their reserves as gold.
- Gold production – This consists of finding the ore, creating access to it, removing it through mining, and processing and refining it.
So how do you invest in gold? There are six main ways…
- Gold coins and bars – The market value of coins is determined by the value of their gold content plus a premium that varies between coins and dealers. Gold bars can be bought in a variety of weights and sizes.
- Exchange-traded gold – Gold is traded in the form of securities on various stock exchanges, and they’re expected to track the gold price almost perfectly. These securities are 100% backed by physical gold held in allocated form.
- Gold accounts – These are offered by gold bullion banks, and include an allocated or unallocated account. With an allocated account, the gold is physically stored in a vault. In an unallocated account, investors do not have specific bars allotted to them.
- Certificates – These are issued by individual banks and offer investors a method of holding gold without taking physical delivery.
- Gold-oriented funds – Nowadays, there are several mutual funds that specialize in investing in the shares of gold mining companies.
- Structured products – These include bonds that are linked to gold, and structured notes, which provide capital protection and a varying degree exposure to price appreciation depending on market condition.
What are the risks of investing in Gold?
With all this said, investing in gold does come with some risks and drawbacks. Here are a few.
- Theft or loss – If you keep your physical gold at home, there’s always the possibility that it’ll get stolen. Purchasing insurance is a way to protect against this, but will increase the costs of ownership. If the gold is in a safe-deposit box at a bank, you won’t have access in an emergency if the bank is closed.
- Fees – Gold held in allocated accounts have storage and insurance fees associated with them. If unallocated accounts are held in the bank’s name, creditors could have a claim on your gold if the bank fails.
- Higher taxes – Mutual funds and ETFs that hold gold are considered collectibles. Capital gains from any collectible are currently taxed at 28%, almost double the normal 15% long-term capital gains tax rate.
- Loss of value – Like most investments, the price of gold fluctuates and can lose value. It’s gone from a high of $850 in 1980, to a low of about $250 in 1999, and even reached the $1,000 mark in 2008. And in the event that gold jewelry needs to be liquidated, the investor will lose the craftsmanship value, since final value is based entirely on the value of the gold.
So, these are the basic elements to consider when looking to understanding gold as an investment.
Do you invest in gold through one of the methods mentioned above? Or if you’re knowledgeable about gold, is there anything that you’d add to this list?
Photo by tao_zhyn
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{ 10 comments… read them below or add one }
I question the use of gold as a hedge against inflation. Gold is a commodity (i.e. it is fungible…basically gold is gold is gold), but so are hundred of other assets like oil, wheat, and cans of soup for that matter. If what you seek is inflation protection, you have to pick the asset that best matches inflation as a whole, and obviously different commodities match inflation at different rates.
If you look at the historic price of gold, it peaked at an all time high in 1980 at about $850, which would equal roughly $2200 in 2010. Gold today is selling in the $1100 – $1200 range, short of it’s all time high by about $1000. So if you bought gold in 1980 and owned it today, you’d be down $1000 per ounce in actual purchasing power. But, you’d owe capital gains tax on the $400 ‘profit’ you made since buying it 30 years ago because the US does not index capital investment basis (i.e. the amount your investment is worth in purchasing dollars).
Doesn’t sound like such an awesome inflation protection to me.
Dave Ramsey says Gold is a bad idea. Here is why
http://www.daveramsey.com/article/dont-buy-gold-sell-it/lifeandmoney_other/text2/
I trust Dave on this.
Dave Ramsey is wrong, on gold anyway. He is right about debt. Gold is more than a bit of safety too. Good article overall though.
Gold’s long term performance against the S&P 500 isn’t all that hot. The problem with gold is that it is counter cyclical, it does better in bear stock markets and times of economic uncertainty. The problem is transitioning through the turns in sentiment and markets. Generally, the stock market spends less time in bear markets than bull markets. If this were not true, the Dow would still be less than a 1000 points as it was during my childhood. Over the past 10 years, Gold has done very well, as it did during the 70′s and early 80′s. Gold prices collapsed in the 80′s and only rose 3% from 1982 to 2007, with most of the gain occurring between 2002 and 2007.
One pitfall that should be avoided. Don’t buy gold or silver bars. They will need to be assayed when selling and this will eat into your profits. Buy coins produced by major countries and you won’t have this to deal with. Also, should a crisis of mass proportion strike, more individuals would be willing to take a coin since it would be easier to know how much gold or silver was in each coin than a bar.
The heading “How To Invest In Gold & Should You” is a question, not a statement. As such, it probably should have a question mark. Just sayin’.
With regard to gold as an “investment” the most obvious demand which the author has chosen to leave out is “gold bugs” who are certain of the collapse of fiat money and, as a result, assign a hyper-aesthetic value to a inert metal which has but a modicum of marginal utility.
As a result the price of gold, valued in fiat money ironically, is vastly overinflated.
I think that the key to investing is to diversify and invest over a period of time. That should hold true whether you are talking about gold, stocks, bonds, or real estate. The fact of the matter is that you can make or lose money in any investment. People have made money in stocks as well as lost money. People have made money in gold as well as lost money. It is not so much the investment tool as how you wield it.
In regards to Dave Ramsey article…whatever, whoever says, forget historical perspective…gold gained more in the last 10 years than any other asset, hugely outperforming real estate and stocks – how is that a bad investment and why would you want to sell it now? I respect his historical analysis but short term look at the numbers!
So how does one start to invest in gold if interested?
Hi Ang. It is actually really easy to get into gold and silver investing, at least compared to other investment types. There are also a number of choices. It is also recommended to invest in physical gold instead of certificates and other forms of indirect ownership. To buy physical gold you can buy scrap metal or buy physical stock in form of coins, bars, bullions or buy with online broker and store it with them. Check out my website for details and some resources of where to start.