Is gold a good investment? – The pros and cons of investing in gold as inflation hedge and store of value

Is buying gold a good investment? This is a question investors are asking in 2020 now that equity market volatility has returned. In addition, governments around the world are injecting liquidity into the financial system, which is leading many analysts to predict rising inflation.

Gold Investment / Investing in Gold
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The result is that gold investment has become one of the major investment themes of 2020. In this post we discuss the history and reasons for investing in gold. We also look at the pros and cons of gold investments, how to invest in gold and a few gold investing strategies.

Why investing in gold?

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Why is gold important? For a relatively small asset class, gold gets a lot of attention. The reason is that gold has become established as a type of “anti-money”. It is viewed as the opposite of fiat currencies like the US Dollar and Euro. The primary reason for this is the fact that supply is limited, while the supply of fiat money is theoretically unlimited. Every year the amount of “above ground” gold increases by just 1.5%. That number is likely to fall in the future as below ground reserves are decreasing by as much as 5% a year.

Around 60% of the demand for gold comes from the jewelry, electrical and medical industries, and this demand is fairly stable. The other 40% of demand comes from investors and speculators. It is this demand that drives the price. This dynamic between supply and demand means that the value of gold is stable. What the price of gold really tells us is the “value” of the US Dollar and other currencies. It is also regarded as a real asset, unlike bonds and currencies which are financial assets. Investing in gold is a way to speculate or hedge against the value of financial assets.

History of gold investing

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A brief history of gold’s role in the economy will give some context to gold investment. Both gold and silver have held a place in the economy for almost as long as commercial activity has existed. Precious metals were a very obvious choice for primitive forms of money. They were used for making jewelry and the fact that supply was limited, meant their value remained in equilibrium. Precious metals were also convenient to use as money as they were easier to transport than any other items of value.

Gold and silver remained the primary form of money until well into the 19th century. In fact, the US Dollar was originally a one-ounce silver coin. The first forms of paper money in Western economies were receipts for gold or silver that was held in a vault. Until the 1870s a bimetallic standard was used in the US, meaning that both gold and silver could be used as money. In 1873 silver was removed from the standard as it was believed too many people had access to unminted silver, which posed a risk to the monetary system. This resulted in the era of the gold standard.

Gold Bullion Selection
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While monetary systems evolved further during the early 20th century, most currencies still represented an ounce of gold. In 1944 it was decided that the gold standard was no longer sustainable. The Bretton Woods system introduced fixed exchange rates, with the US Dollar fixed at $35 per ounce of gold. This effectively fixed the value of gold, rather than of currencies. The Bretton Woods system initially worked well, but it too became unsustainable, especially for America. In 1971 the US pulled out of the system which effectively led to its collapse. This allowed the US dollar to weaken, and the price of gold to float freely.

Gold vs. stocks and inflation

Before 1971, there was little point investing in gold as the price was fixed. However, during the 1970s gold became a legitimate asset class. During this period, US inflation spiked to above 14%, and gold quickly became established as an inflation hedge. By 1980 the price had risen to over $2200, though it weakened substantially over the next two decades when inflation declined, and the stock market performed well.

Since the 1970s gold returns have often had a negative correlation with stock market returns. Owning gold is therefore viewed as way to hedge against market volatility. Investing in gold is generally effective when there is speculation that central banks will increase the money supply, or when other factors may lead to hyperinflation.

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A gold investment will also often perform well during a financial crisis, when geopolitical tension increases, or when war breaks out. The oil price is strongly associated with inflation. Any hostility close to oil producing nations – notably in the Middle East – can lead to interruption of oil supply. This can result in higher oil prices and later to inflation. This is why the gold price often rises when geo-political tension rises.

If the global financial system were to completely collapse, the only assets that would retain value would be real assets. To date, no crisis has resulted in a total collapse of the financial system. But each financial crisis takes us a little bit closer to this sort of disaster. This is why gold often responds positively to any sort of global crisis. At the very least, gold can be used as a place to store wealth in times of uncertainty.

Types of gold investments

There are several ways to own gold, both in its physical form, or indirectly. The following are the three broad categories:

Physical gold

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A direct gold investment means you own physical gold. This can be in the form of gold bullion or rare and numismatic coins. Gold bullion, which can be in the form of gold bars or officially minted coins, is bought and sold at a price close to the spot price of gold. In the case of rare coins and numismatic coins, the value depends on the quantity of gold in each coin, as well as other factors. The rarity, the age, and condition of a coin will all affect its value. Investing in gold bars and coins introduces a range of new challenges like storage, transport, and insurance. On the other hand, you know exactly what you own and there is no counterparty risk.

Paper gold

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Over the last 50 years, a large number of financial products offering exposure to the gold price have emerged. First came exchange traded futures and options, then exchange traded funds (ETFs), and more recently contracts for difference (CFDs). These products allow gold to be traded electronically, which is cheaper and more efficient. However, there are some concerns that these products mean you are still to some extent exposed to the financial system. Ultimately whether or not you own paper gold or physical gold will depend on your reasons for owning it.

Gold stocks

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The indirect way to buy gold is by investing in gold mining stocks. In this case you are buying shares in a company that actually produces gold. Their costs are mostly fixed, while their revenue fluctuates with the gold price. One of the advantages of owning shares in gold miners is that you can earn dividends, unlike any other type of gold share. Typically, gold miners with low production costs are able to pay regular dividends.

Marginal mines are those with high production costs. These mines are highly leveraged to the gold price and their share prices can be quite volatile. Gold streaming companies are a different type of gold stock. These are companies that provide capital to gold mines in return for an option to buy gold from the mine at a fixed price. Gold streamers can diversify their risk across lots of mines and provide income for investors.

Gold stocks vs. direct exposure to the price of gold

So, which is the best way to invest in gold? The following chart tracks the gold price (in black) against some of the largest gold miners and streamers in the world over the last five years.

Gold vs. Gold Mines
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At first glance it may appear that gold stocks are a far better type of gold investment. However, it’s important to realize that this is a period during which the gold price rose 40%. Gold miners can decline just as much, or more, when the gold price falls. In the second half of 2016 the gold price fell 16%, while the stock price of many of these miners fell more than 40%.

It’s also worth noting that these are the biggest miners in the world, and they typically have the lowest production costs. The stock prices of smaller miners are even more volatile. Gold mines introduce new risks and challenges, and they face rising costs as a mine ages. Investing in gold stocks requires an understanding of the industry and all the factors that affect stock prices.

If you are investing in gold to hedge your portfolio against volatility and inflation, exposure to the gold price itself will be more reliable. If on the other hand, you are confident that the gold price will rise and you want to maximize returns, gold stocks are the better option. Before investing in gold, it’s worth being aware of the positives, the negatives, and the risks.

5 Reasons to invest in gold

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  • Because it is a real asset with limited supply, gold is an effective inflation hedge.
  • Gold typically performs well during recessions, bear markets, and when stock market volatility is high.
  • Gold has a low correlation with most asset classes. This is a useful characteristic when building a diversified investment portfolio. A gold investment can be an effective way to hedge portfolio risk and volatility.
  • While interest rates are low, the opportunity cost of investing in gold is low. In other words, by owning gold you are not missing out on high interest or dividend payments.
  • Gold is a tangible asset and you know exactly what you own. On the other hand, the value of financial assets is based on expectations about the future which involves uncertainty.

5 Reasons not to invest in gold

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  • Unlike cash, stocks and bonds, gold does not pay any sort of yield. In fact, storing and insuring gold can result in a negative yield.
  • What is gold worth? Because there is no yield, it’s impossible to calculate the intrinsic value of gold. The gold price is driven entirely by supply and demand, which means its price has a speculative nature to it.
  • Liquidity can be a problem with a gold investment. If you own physical gold, you need to store and transport it. If you own gold indirectly, you may be exposed to the same liquidity problem as other financial assets in the case of a collapse of the financial system.
  • For physical gold, transaction costs are higher than they would typically be for assets that are electronically traded. This is especially true for gold coins.
  • Speculation and the use of leverage are creating increasing risks for anyone investing in gold. When you use leverage to buy an asset, you will probably not be able to ride out a meaningful decline. If there are too many speculative long positions, and those positions are leveraged, the price can fall substantially in a short period.

Three approaches to investing in gold

If you are thinking of investing in gold, it’s important to be clear about your goals and your reason for doing so. One way to do this is to split your gold investment across the following three strategies. This will allow you to spread your risk, while exploiting all the potential benefits of gold as an investment.

Strategic asset allocation

Asset Allocation
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Your strategic asset allocation is designed to optimize your return for a given level of risk over the long term. Allocating a small amount of your investment portfolio to gold should reduce volatility. It would also act as a hedge in the case of hyperinflation or a collapse of the financial system.

This investment should not be based on a view on the gold price, but on gold’s low correlation to other asset classes. The returns generated from a strategic allocation to gold will depend on the price you pay. If you can buy into weakness, it is more likely that long term returns will be positive.

Tactical asset allocation

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A more active form of asset allocation is TAA, or tactical asset allocation. This entails moving 10 to 20% of your portfolio back and forth between riskier assets and safe haven assets as fundamentals improve or deteriorate. The safe haven assets that are most suitable for this are gold, bonds, and cash. TAA would usually entail moving 3 to 5% of a portfolio to each of these assets.

There is no clear line between market timing and tactical asset allocation, and market timing is not easy. So, this strategy should also be considered a method of portfolio hedging rather than a way to generate returns. When a correction or bear market begins no one knows how long it will last. TAA is way to protect a portfolio in the event of a prolonged market slump but may hurt performance if the correction is short lived.

Trend following

Gold Trend Following
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One of the characteristics of gold is that trends are often persistent. This is often a result of many of the biases that we covered in our behavioral finance post. If your objective is to profit from moves in the gold price, following the trend is often easier than trying to forecast the price using fundamental analysis.

This means you will have a third allocation to gold when the price is rising but exit that position when it’s falling. You can use trendlines or moving averages to follow the trend. You can even short sell gold during downtrends, though this does introduce a new set of risks.

Alternatives to gold investment

Silver Bullion / Gold Investment Alternative
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Gold is not the only precious metal you can use to hedge against volatility and inflation. Some investors actually believe silver is a better investment because there is more industrial demand for the metal. Typically, gold is slightly better volatility hedge, while both silver and gold are effective inflation hedges.

Hedge funds like LEHNER INVESTMENTS Data Intelligence Fund that employ long / short and market neutral investment strategies can also be used to hedge a portfolio against a market crash. Other alternative asset classes like real estate and private equity also have a low correlation with the stock market and bonds. These can also be used to hedge a portfolio over the long term.

Conclusion: Investing in gold

So, is gold a safe investment? Over the long-term stocks have outperformed gold by a wide margin. What happens in the future will depend on the performance of companies and the economy, as well as on inflation. However, gold is likely to retain value and it’s hard to imagine a scenario where gold investors are wiped out.

Gold is also an important tool for investors. Because it has a very low, and even negative, correlation with other asset classes it’s one of the most effective volatility hedges you can own. A gold investment should also pay off inflation returns, and especially if monetary policy leads to hyperinflation.

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Comments (3)

My wife and I really want to plan for the future by investing in something that will keep its value. She really wants to invest in some gold coins that we can give to the kids to keep. It could be really useful to buy them from a professional that we can trust. I liked what you said about how we can get a strategic allocation from gold based on the low correlation to other asset classes.

You made a good point when you mentioned that gold is a real asset with limited supply which makes it a good investment, especially during recessions. My brother has shown an interest to buy some gold coins so he can use them in case of any emergency situations. I will advise him to find a reliable service that can aid him in starting his investment in precious metals.

In a digital currency environment who will buy gold?

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