Historically, gold has played a major role in the economies of many nations. Although it is no longer a primary form of currency, gold is still a solid, long-term investment and may be a valuable portfolio addition, particularly in a bear market.
Gold was considered a universal currency for hundreds of years. Due to its recognized value worldwide, a gold standard was used as far back as the Byzantine Empire over 1,500 years ago. Until recently, in fact, gold was used as the world reserve currency.
In 1944, upon the signing of the Bretton Woods Agreement, the dollar replaced gold as the world reserve currency. But even after this agreement, gold continued to be used to back up various countries’ domestic currencies. However, in 1971, Richard Nixon removed the gold standard in the U.S. and other countries soon followed.
Advantages of Gold as an Investment
Although it is no longer a primary form of currency in the developed world, gold remains a popular investment for a number of reasons.
- Liquidity. Gold can be easily converted into cash anywhere in the world. Aside from actual cash, the liquidity and universality of gold is unparalleled.
- Holds its value. Gold tends to maintain its value over time. Economists argue that even the price of gold is not indicative of its value. That is, even if the price decreases, the underlying value of gold does not change much. This is largely because there is a fixed quantity of gold due to the fact that it is a commodity, whereas the U.S. dollar, which is a form of fiat currency, holds no inherent value.
- Hedge against inflation. Gold rises in value when inflation takes hold. Since gold is priced in U.S. dollars, any deterioration in the dollar will logically lead to a higher price of gold. As a result, during inflationary times, gold offers a much more stable investment than cash.
- Diversification. Adding different securities to your portfolio is an essential way to diversify and lower the overall risk of your investments. Moreover, because gold often moves inversely to the stock market and currency values, it provides an especially effective way to diversify.
- Universally desired investment. Gold is still a universal commodity. Although countries sell their currency futures, treasuries, and other securities around the world, unlike gold, they are subject to political chaos.
- Gold is used as an input in products. Since gold is used in the production of various products including jewelry and electronics, there is a reliable demand that further stabilizes the price of gold. Moreover, in times of increased demand, these markets can force the price of gold higher.
Disadvantages of Investing in Gold
While gold can be a great investment for a number of reasons outlined above, be aware of the disadvantages before investing:
- Gold doesn’t earn passive income. Other investments such as stocks and bonds may derive a portion of their value from passive income in the form of interest and dividends. However, the only return you can make on gold is when the value increases and you decide to sell.
- Gold can create a bubble. In turbulent economies, many people start investing in gold, but when investors start to panic, gold can become overpriced. This, in turn, means that your investment could lose value once the price corrects itself.
- Need physical storage and insurance. If you choose to buy actual, physical gold, you will not only need to store it, but you will need to insure it as well. Otherwise, you won’t be able to replace it if it becomes damaged or stolen.
- Capital gains tax rates are higher on most gold investments. Since gold is considered a collectible in the U.S., the capital gains tax rate is 28%, which is much higher than the ordinary capital gains rate of 15%. That said, mining companies that don’t invest in gold directly are still taxed at the ordinary rate.
- Increases in gold value coincide with local currency devaluation. Many economists argue that gold only increases in value when the dollar is devalued or inflation is strong. As a result, critics feel that gold doesn’t offer adequate returns in other markets.
When to Invest in Gold
The best time to invest in gold is when inflation is expected to take hold and force down the value of the national currency. The earlier you can detect such drops, the more room you have to make a profit. Leading indicators such as stock market declines and political turmoil may indicate a future devaluation of your country’s currency. Announcements by reserve banks to print out more local currency can also indicate a good time to invest in gold.
When the local currency is strong, and inflation is not expected, there is not much room for the price of gold to rise. With that said, if there are expectations of increased demand from markets that require gold, such as jewelry and electronics, consider investing in gold to benefit from the potential price pressure.
Practically speaking, however, a buy-and-hold passive investing strategy may be best for the ordinary gold investor. Since economies tend to be cyclical, buy when the price of gold is down, whether or not your country is currently going through turmoil or you think it’s headed for some. In this way, you don’t have to worry about buying when everyone else is buying and driving the price up.
What Percentage of a Portfolio Should Gold Make Up?
There is no hard and fast rule as to how much gold you want to hold in your portfolio. This will depend on how you feel about the market, how comfortable you are with volatility, and your overall financial needs and timeline.
Because gold is one of the few investments that performs well in a bear market, consider if you’re feeling bearish or bullish, and use it to round out an aggressive, stock-heavy portfolio. Ultimately, you should employ the same portfolio management strategies for allocating gold as for purchasing other investments.
How to Invest in Gold
There are many different ways to invest in gold:
- Buy gold directly. You can buy gold directly in the form of bullion or coins. You will then hold onto physical quantities of gold, which can be sold at a later date. It can feel good to have gold actually in your possession, but you need to be careful with it. The biggest downside is that you will have to pay to have it insured or stored.
- Buy shares in a gold company. You can also purchase stock in a company that produces gold. The value of the stock is going to be strongly correlated with the value of gold itself. You may also be paid dividends on your shares.
- Gold futures and options. You can invest in gold through financial derivatives that specialize in gold investments like call and put options. A call is appropriate if you expect the value of gold to increase. On the other hand, you’d purchase a put if you expect the price of gold to drop. Like other derivatives, gold options and futures are risky; you have the potential to earn high returns or incur huge losses.
- Invest in a gold ETF. A gold ETF is an exchange-traded fund that specializes in investing in a range of gold securities. Such diversification can somewhat minimize your risk. Two popular gold ETFs trading on the market are the streetTRACKS Gold Trust and the iShares COMEX Gold Trust.
Gold can be a profitable investment when all others fail. If you are concerned about inflation or the devaluation of your country’s currency, you may want to add gold to your portfolio. That said, understand the specific gold investment you’re considering thoroughly before you actually invest. For example, exactly how much will it cost you to store and insure physical gold? What are the tax differences for your income tax bracket between investing in a gold ETF or a gold mining ETF? Knowing the details can make a big difference when it comes to profitability.
As tempting as it may be to buy a lot of gold in a struggling economy, try not to get carried away. Gold bubbles exist, and in order to prevent yourself from being over-exposed to any asset class, you always want to maintain a well-diversified portfolio.
What are your thoughts on investing in gold in a down economy?