Investors can invest in gold through exchange-traded funds (ETFs), buying stock in gold miners and associated companies, and purchasing a physical product such as coins or bullion. They usually have as many reasons for investing in the precious metal as they do methods to make those investments.
Some argue that gold is a relic that no longer holds the monetary qualities of the past. In a modern economic environment, paper currency is the money of choice. Critics contend that gold’s only benefit is the fact that it is a material used in jewelry. On the other end of the spectrum are those who assert that gold is an asset with various intrinsic qualities that make it unique and necessary for investors to hold in their portfolios.
In the end, economists and market professionals view gold as a portfolio diversifier and potential hedge against inflation. Gold may also be a safe-haven asset when the economy turns sour and the prices of stocks and bonds suffer. In the end, whether to invest in gold will depend on your individual circ*mstances and market outlook.
Key Takeaways
- Gold bugs have often encouraged investors to own the precious metal as part of a diversified long-term investment portfolio.
- Gold is seen as a hedge against inflation and a store of value through market ups and downs.
- Investors can hold physical gold directly in the form of coins, bullion, or jewelry; or indirectly via mutual funds, exchange-traded funds (ETFs), gold derivatives, or gold-mining stocks.
- However, holding gold comes with unique costs and risks, and the data shows that gold has historically disappointed on several of its purported virtues.
A Brief History of Gold
To fully understand the purpose of gold, one must look back to the start of the gold market. Gold’s history in society began well before even the ancient Egyptians, who started forming jewelry and religious artifacts. Yet it wasn’t until around 560 B.C. that gold started to act as a currency.
At that time, merchants wanted to create a standardized and easily transferable form of money that would simplify trade. The creation of a gold coin stamped with a seal seemed to be the answer, as gold jewelry was already widely accepted and recognized throughout various corners around the Earth.
Following the advent of gold as money, its importance continued to grow throughout Europe and the United Kingdom, with relics from the Greek and Roman empires prominently displayed in museums around the world, and Great Britain developing its own metals-based currency in 775. The British pound (symbolizing a pound of sterling silver), shillings, and pence were all based on the amount of gold (or silver) represented. Eventually, gold symbolized wealth throughout Europe, Asia, Africa, and the Americas.
The U.S. Bimetallic Standard
The United States continued with this gold tradition by establishing a bimetallic standard in 1792. The bimetallic standard simply stated that every monetary unit in the U.S. had to be backed by either gold or silver. For example, one U.S. dollar was the equivalent of 24.75 grains of gold. In other words, the coins that were used as money simply represented the gold (or silver) that was presently deposited at the bank.
However, this gold standard didn’t last forever. During the 1900s, several key events eventually led to the transition of gold out of the monetary system. In 1913, the Federal Reserve was created and started issuing promissory notes (the present-day version of our paper money) that could be redeemed in gold on demand. The Gold Reserve Act of 1934 gave the U.S. government title to all the gold coins in circulation and put an end to the minting of any new gold coins.
In short, this law began establishing the idea that gold or gold coins were no longer necessary in serving as money. The U.S. abandoned the gold standard in 1971 when its currency ceased to be backed by gold.
Gold in the Modern Economy
Even though gold no longer backs the U.S. dollar (or other worldwide currencies, for that matter), it still carries importance in today’s society. It is still critical to the global economy. To validate this point, look no further than the balance sheets of central banks and other financial organizations, such as the International Monetary Fund (IMF).
At present, central banks and multilateral financial institutions are responsible for holding almost one-fifth of the world’s supply of above-ground gold. In addition, several central banks have added to their gold reserves lately, reflecting concerns about the long-term global economy.
Gold Preserves Wealth
The reasons for gold’s importance in the modern economy center on the fact that it has successfully preserved wealth throughout thousands of generations. The same, however, can’t be said about paper-denominated currencies. To put things into perspective, consider the following example:
In the early 1970s, 1 ounce of gold equaled $35. Let’s say that at that time, you had a choice of either holding an ounce of gold or simply keeping the $35. They would both buy you the same things, like a new business suit or a fancy bicycle. However, if you had an ounce of gold today and converted it for today’s prices, it would still be enough to buy a new suit, but the same can’t be said for the $35. In short, you would have lost a substantial amount of your wealth if you decided to hold the $35 as opposed to the ounce of gold, because the value of gold has increased, while the value of a dollar has been eroded by inflation.
Gold as a Hedge Against the Dollar
The idea that gold preserves wealth is even more important in an economic environment where investors are faced with a declining U.S. dollar and rising inflation. Historically, gold has served as a hedge against both of these scenarios. With rising inflation, gold typically appreciates. When investors realize that their money is losing value, they will start positioning their investments in a hard asset that has traditionally maintained its value. The 1970s present a prime example of rising gold prices in the midst of rising inflation.
The reason why gold benefits from a declining U.S. dollar is because gold is priced in U.S. dollars globally. There are two reasons for this relationship:
- Investors who are looking at buying gold (i.e., central banks) must sell their U.S. dollars to make this transaction. This ultimately drives the U.S. dollar lower, as global investors seek to diversify out of the dollar.
- A weakening dollar makes gold cheaper for investors who hold other currencies. This results in greater demand from investors who hold currencies that have appreciated relative to the U.S. dollar.
Gold as a Safe Haven
Whether it is the tensions in Ukraine, Eastern Europe, the Middle East, Africa, or elsewhere, it is becoming increasingly obvious that political and economic uncertainty is another reality of our modern economic environment. For this reason, investors typically look at gold as a safe haven during times of political and economic uncertainty.
History is full of collapsing empires, political coups, and failed currencies. During such times, investors who held gold were able to successfully protect their wealth and, in some cases, even use the commodity to escape from the turmoil. Consequently, whenever news events hint at some type of global economic uncertainty, investors will often buy gold as a safe haven.
Gold as a Diversifying Investment
In general, gold is seen as a diversifying investment. It is clear that gold has historically served as an investment that can add a diversifying component to your portfolio, whether you are worried about inflation, a declining U.S. dollar, or even protecting your wealth.
If your focus is simply diversification, gold isn’t correlated to stocks, bonds, or real estate.
Gold as a Dividend-Paying Asset
Gold stocks are typically more appealing to growth investors than to income investors. Gold stocks generally rise and fall with the price of gold, but there are well-managed mining companies that are profitable even when the price of gold is down. Increases in the price of gold are often magnified in gold stock prices. A relatively small increase in the price of gold can lead to significant gains in the best gold stocks, and owners of gold stocks typically obtain a much higher return on investment (ROI) than owners of physical gold.
Even those investors focused primarily on growth rather than steady income can benefit from choosing gold stocks that demonstrate historically strong dividend performance. Stocks that pay dividends tend to show higher gains when the sector is rising and fare better than non-dividend-paying stocks when the overall sector is in a downturn.
The Gold Mining Sector
The mining sector, which includes companies that extract gold, can experience high volatility. When evaluating the dividend performance of gold stocks, consider the company’s performance over time in regard to dividends. Factors such as the company’s history of paying dividends and the sustainability of its dividend payout ratio are two key elements to examine in the company’s balance sheet and other financial statements.
A company’s ability to sustain healthy dividend payouts is greatly enhanced if it has consistently low debt levels and strong cash flows, and the historical trend of the company’s performance shows steadily improving debt and cash-flow figures. Because any company goes through growth and expansion cycles when it takes on more debt and has a lower cash-on-hand balance, it’s imperative to analyze its long-term figures rather than a shorter financial-picture time frame.
Different Ways of Owning Gold
One of the main differences between investing in gold several hundred years ago and today is that there are many more investment options, such as:
- Gold futures
- Gold coins
- Gold companies
- Gold ETFs
- Gold mutual funds
- Gold bullion
- Gold jewelry
Is It a Good Time or a Bad Time to Invest in Gold?
To assess the merits of investing in gold, let’s check its performance against that of the Index over time. This is unsurprising, because gold is thought to be both an inflation hedge and a safe haven during bear markets—and both of these occurred throughout 2022.
That said, the period of time that we look at is incredibly important. Looking at longer or shorter time frames will variously show gold or the broader market outperforming, sometimes by a wide margin. For example, over the five-year period that ended in January 2023, the S&P 500 outperformed the price of gold.
The point here is that gold isn’t always a good investment. The best time to invest in almost any asset is when there is negative sentiment and the asset is inexpensive, providing substantial upside potential when it returns to favor, as indicated.
Is gold a good investment for diversification?
Gold is often considered a good investment for diversification, as it may be less correlated with other assets such as stocks or bonds. This means that the price of gold may be less affected by movements in other asset classes, which can help to reduce overall portfolio risk.
In addition, gold historically has been seen as a hedge against inflation, as it has the potential to maintain or increase its value over time, even in the face of rising prices. However, it is important to keep in mind that investing in gold isn’t without risk, and it may not always provide a positive return. The price of gold can be affected by a variety of factors, including economic conditions, political events, and investor sentiment, and it is possible to lose money by investing in gold.
What are the potential risks of investing in gold?
There are several potential risks to investing in gold, including:
- Price volatility: The price of gold can be volatile, and it may fluctuate significantly over short periods of time. This can make it difficult to predict its value and can make it a risky investment.
- Inflation risk: Some investors buy gold as a hedge against inflation, but there is no guarantee that the price of gold will increase along with the rate of inflation.
- Political risk: Gold prices can be affected by political events, such as wars, national elections, and changes in government policies.
- Storage and insurance costs: If you physically own gold, you will need to store it safely and insure it against loss or damage. These costs can add to the overall cost of your investment.
It’s always a good idea to carefully consider the risks of any investment before making a decision. You may want to consult with a financial advisor or do your own research to determine if investing in gold is a good fit for your investment portfolio.
How can I invest in gold without physically holding it?
There are several options for investing in gold without physically holding it, including:
- Gold mining stocks
- Mutual funds or exchange-traded funds (ETFs) that invest in gold
- Gold-based savings plans or gold certificates
- Gold futures contracts
- Options on gold futures
The Bottom Line
There are advantages and disadvantages to every investment.
If you are opposed to holding physical gold, then buying shares in a gold mining company may be a safer alternative.
If you believe that gold could be a safe bet against inflation, then investing in coins, bullion, or jewelry are paths that you can take to gold-based prosperity.
Gold can also be a safe haven when the economy becomes uncertain or a recession looms.
Finally, if your primary interest is in using leverage to profit from rising gold prices, then the futures market might be your answer. However, there is a fair amount of risk associated with any leverage-based holdings.
