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Investing in Gold – History, Determining If It’s a Good Investment

By Michael Lewis

goldHumankind’s fascination with gold can be dated back as far as 4000 B.C., and for much of our collective history, possession of gold was a sign of wealth and status restricted solely to governments and nobility. Eventually, the first gold coins are believed to have initially financed long-distance trading around the world – around 500 B.C., Darius the Great of the Persian Empire is thought to have minted the first coin, the “daric,” to facilitate the expansion of his empire and the needs of his army as it moved into foreign territories.

Many countries came to use gold and silver coins as currencies for centuries. However, during the worldwide depression of the 1930s, every industrialized nation ceased using the gold standard, subsequently severing the close link between the value (and quantity) of gold and the value of money.

Despite this, gold continues to be a sought-after commodity due to its scarcity and reputation as a hedge against monetary or societal collapse. But does it deserve a place in your portfolio?

Gold in Modern Civilization

Today, gold is available in several forms, including the following:

  • Historic Collectors’ Coins. Minted as currency by many countries, these coins are now collected as much for their numismatic value as their gold content. Like other collector’s items, such as stamps and fine art, only experts, or those who have access to experts, should consider this investment.
  • Collector Gold Coins. Issued by countries and commercial businesses, these coins are priced according to their weight and purity. The more popular coins are the Canadian Maple Leaf, the South African Krugerrand, and the American Eagle.
  • Gold Bars. Available by weight of one gram, one ounce, ten ounces, and one kilo (32.15 ounces) generally with 99.99% purity, bars are also referred to as “gold bullion.” A standard gold ingot like that found in the U.S. Fort Knox Depository, and commonly depicted in movies, is seven inches long, three and five-eighths inches wide, and one and three-quarters inches high, and weighs 27.5 pounds. At current market prices, an ingot would have a value in excess of $500,000, much too expensive to support an active investor market.
  • Common Stock of a Gold Mining Company. Ownership in a company whose sole business is the search and discovery of gold, and the potential value of the element in the resources not yet produced is a common type of gold investment.
  • Gold Exchange Traded Fund (ETF). A gold ETF does not typically hold gold as a commodity, but tracks its price with a combination of financial derivatives.
  • Gold Exchange Traded Notes (ETN). A gold ETN is a debt security that’s value fluctuates based upon the price of the underlying index – in this case, the price of gold. While this investment includes credit risk, the benefit of being taxed as a long-term capital gain rather than paying ordinary interest exists with this vehicle.

Gold is not money or currency, but an investment which must be converted into money before it can be used to purchase other assets. Of course, individuals and businesses can agree to exchange an amount of gold for a service or product – as was done for centuries – but it would require negotiation about the relative value of each, a timely and potentially risky process for both parties.

gold investment

America’s Relationship With Gold

The Constitution of the United States gives Congress the power to coin money. In 1792, the Coinage Act established the U.S. Mint and set the value of different species of coin:

  • Eagle. Set at a value of $10, the eagle was to contain 270 grains of standard gold.
  • Half-Eagle. With a value of $5, the half-eagle contained 135 grains of standard gold.
  • Quarter-Eagle. A quarter-eagle was worth $2.50 and had 67.5 grains of standard gold.
  • Dollar or Unit. The dollar was established to be equal to the value of a “Spanish milled dollar” and to contain 416 grains of standard silver.

The Act also established half-dollars, quarter-dollars, dimes, and half-dimes, each containing silver grains, as well as cents, half-cents, and mils (1,000th of a dollar) containing copper, each of the lesser coins representing different percentages of the dollar. The Act also appeared to set the ratio of the value of gold to silver, which at the time was 1 to 15.4. However, the gold coins, minted without denomination, floated relative to the value of the commodity silver, rather than the dollar coin – if the value of silver moved up or down per ounce, the gold coin’s value followed.

American gold coins as currency were last minted in 1933 and included the $20 Saint Gauden Double Eagle. In 1986, the U.S. began minting the American Gold Eagle coin as a collector’s item – its weight, content, and purity guaranteed by the U.S. government. The American Buffalo Gold Bullion coin of 99.99% purity was offered for the first time in 2011.

The Gold Standard

Paper currency, much more convenient than actual amounts of gold or silver, was issued by the United States between 1862 and 1964 in two forms:

  • Gold Certificates. These certificates, issued between 1862 and 1933, gave the holder the right to exchange the paper note for the equivalent amount of gold coins at a fixed value of $20.67 per troy ounce.
  • Silver Certificates. Issued from 1878 to 1964, a silver certificate gave the holder the right to exchange the note for face value in silver coins. In the last year (1968), the holder received raw silver bullion.

Effectively, the amount of money which could be issued was based upon the amount of gold and silver held by the United States Federal Government. Private individuals could hold gold in the form of coins or bullion without restriction at that time. In response to the hoarding of gold coins and its effect upon the economy, President Franklin Roosevelt issued Executive Order 6102 in 1933 which required all citizens to give gold coins, gold bullion, and gold certificates to the Federal Reserve in exchange for Federal Reserve notes at a rate of $20.67 per ounce of gold exchanged. Failure to exchange was punishable by fines, prison, or both.

In 1934, the Gold Reserve Act raised the value of gold from $20.67 to $35 per ounce, a price that remained in place until 1971. Individuals were again allowed to own gold certificates in 1964, but they were no longer redeemable by the government for gold. U.S. citizens were again allowed to own gold in 1974 by executive order of President Gerald Ford.

Our Modern Monetary System

In 1971, President Richard Nixon severed the last connection between gold and the United States monetary system, unilaterally canceling the direct convertibility of the U.S. dollar to gold. This action was a response to the dollar’s drop in value against other world currencies. Nixon’s act led to the floating system of international exchange rates which are still in place today. These allow the Federal Reserve to print as much or as little money as it deems appropriate to meet economic conditions.

At the same time, it introduced volatility into the exchange rate and increased risk in a world where goods and services are sold globally. According to conservative columnist David Frum, “The modern currency float has its problems.” Frum claims that a classical gold standard leads to chronic deflation and periodic depressions. However, he also believes that a regime of managed currencies tethered to gold produces too many regulations and controls, and that a floating currency makes for chronic inflation and bubbles – the American lot since 1971. However, this last system is favored by Frum – he calls it “the worst option except for all the others.”

Clearly, investors should view gold solely as an investment, no longer secured by a fixed price guaranteed by the U.S. government or any other national government. According to a 2012 article in Business Insider, “Very few countries hold meaningful gold positions when compared to their money supplies. Even Singapore, generally regarded as having one of the healthiest balance sheets on the planet, holds a mere 2% of its money supply in gold.”

Gold is predominately hoarded, historically in the form of jewelry and artifacts, but increasingly as investment. According to the International Monetary Fund, the United States is the largest owner in the world with an estimated 8,134 tons, representing less than 5% of total global reserves. An estimated 2,500 tons of gold are mined each year, continuing to add to worldwide inventory.

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Gold as an Investment

Whether you should have gold in your portfolio depends upon your projection of future political and economic events, as well as the capital you have to invest and the period of time you intend to hold your investment. If you are an ardent gold bug, a person who thinks worldwide calamity is likely, or an industry advocate – such as BullionVault, which claims “A solid gold investment sets you free from the risk of credit default or banking failures” – you either already own gold, or are wondering when to buy and how much to buy.

Despite such conviction, a review of the price volatility since 1980 would suggest that “when” you buy gold is a very important determinant of future profits. Over the past 25 years, its price has ranged from a low of $347.84 in August 2001, to more than $1,900 per ounce in 2011, selling today for around $1,240 an ounce.

If you have decided to buy gold, take your time and be sure that you pay a reasonable price considering the current investment environment. If you are making a decision whether to add gold to your portfolio, consider how it may perform relative to the following investment parameters:

  • Security. According to a 2012 New York Post article, at least 10 fake gold bars were sold to unsuspecting dealers in Manhattan’s midtown diamond district. This report followed a request by 2010 presidential candidate Ron Paul, the U.S. Treasury Department, and U.S. Mint to verify the gold content in the nation’s inventory. A recent Google search produced more than 2.3 million references to the term “fake gold bars,” 363,000 identified with China. Some websites even demonstrate how to produce fake bars. Be aware that gold is an unregulated commodity generally traded through a network of unregulated dealers. You should restrict your transactions to reputable firms of long standing to ensure you get what you buy.
  • Safety of Principal. While gold has always been attractive to own for emotional reasons, its intrinsic value is considerably lower than its market value. In fact, JP Morgan Asset Management declares, “Gold does not have a fundamental intrinsic value.” It is not tied to global consumption, does not provide any cash flow or right to future earnings, and does not guarantee repayment at a later date. Gold’s historic price is driven by scarcity and robust, sometimes frenzied demand as a hedge against future economic disasters or government failures. Since its value is affected by emotion, it is impossible to accurately project future price movement. However, there are significant profit opportunities if you are willing to assume a comparable degree of risk.
  • Performance and Volatility. The market price of gold was restricted in modern times until the United States ceased converting dollars into gold, letting its value float according to supply and demand. The price per ounce soared from $215.73 in January 1971 to a high over $1,900 in 2011 and currently sells for $1,238.88. Like many investments, gold is more volatile than advocates would have you believe. Whether or not an investor makes money on it depends entirely upon the acquisition and sale dates. By any account, it has been a wild ride. It is interesting to note that, for a range of investment holding periods of eight years and longer, the NASDAQ index has significantly outperformed gold, according to Macrotrends.
  • Liquidity. Buying and selling gold coins and bullion requires the use of dealers, confirmation of quality, and knowledge of volatile spot prices. While not as easy to buy and sell as common stocks and bonds, transactions in gold – subject to the aforementioned requirements – are faster than, and at least as simple as, many real estate transactions.
  • Investment Costs. According to TheStreet columnist Alix Steele, markups can reach 75% above the spot price of gold depending upon its form and purity. For example, an American Gold Eagle or Buffalo coin sells for the price of gold the previous day plus 5%. Dealers set their own prices so purchasers should check several sources to find the best one. Once purchased, one must also consider the cost of storage, whether kept in a bank safe deposit box or a private security vault. Investors who take delivery and store their assets at home are likely to incur some costs to provide minimal security for it.

Many gold investors, seeking to avoid the problems attendant with its ownership, purchase common stock in gold mining companies, ETFs, or gold exchange traded notes (ETNs) which are focused on the price of gold or gold stocks. Since the latter are derivatives which depend upon the price of the underlying commodity, their value can actually be more volatile than gold itself. J.C. Doody, editor of the website goldstockanalyst, says, “If you do go the gold stock route, you have to be prepared for the roller coaster ride.” If the price of gold drops 10%, stock prices of gold companies can drop 20% to 30%, according to Doody.

The rationale for owning gold is driven by the assumption that it can retain its value in the event of widespread war, monetary failure, government collapse, or societal turmoil – fears escalated by certain political commentators who may be supported by the gold industry itself. As with all emotional markets – whether driven by euphoria or fear - there are substantial profit opportunities for those who can accurately project public reactions. In other words, profits can come as a result of public expectations of an event, regardless of whether or not the event actually materializes. After all, while no one truly knows what would happen in the event of an institutional collapse, it is unlikely that any asset would emerge unscathed in such chaos.

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Final Word

If you believe, after considering the benefits and risks of owning gold, that an investment is warranted, follow the same good practices that should be used for every investment: Limit your risk by diversification and take a long-term view. Practically speaking, invest no more than 3% to 10% of your portfolio in the commodity and its derivatives (bullion, coins, ETFs, ETNs, and gold mining stocks). Also, be sure to work with reputable dealers and avoid over-reaction in times of stress.

If you decide to forgo a gold investment, take heart in the example of Warren Buffett, who has counseled the trustee of his will: Put 10% of the cash in short-term government bonds and 90% in very low-cost S&P 500 index funds.”

Does gold have a place in your portfolio?

Michael Lewis
Michael R. Lewis is a retired corporate executive and entrepreneur. During his 40+ year career, Lewis created and sold ten different companies ranging from oil exploration to healthcare software. He has also been a Registered Investment Adviser with the SEC, a Principal of one of the larger management consulting firms in the country, and a Senior Vice President of the largest not-for-profit health insurer in the United States. Mike's articles on personal investments, business management, and the economy are available on several online publications. He's a father and grandfather, who also writes non-fiction and biographical pieces about growing up in the plains of West Texas - including The Storm.

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