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