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The Pros and Cons of Investing in Gold

By Investing Basics Bankrate.com

Investing The pros and cons of investing in gold

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Gold might be a glittering temptation for investors looking to fatten their investment returns with a relatively safe commodity. But it's far from foolproof.

Indeed, gold shouldn't be considered an investment at all, says Chris Hyzy, chief investment officer at U.S. Trust, the private wealth management arm of Bank of America in New York. Rather, the precious metal acts as a hedge, or a way to try to protect wealth against the risk of loss in such asset classes as real estate, equities and bonds, he says.

Traditionally, investing in gold has been used as a hedge against inflation. That thinking still holds, though worries over inflation might be better understood as a fear of the loss of purchasing power or that "the money we currently have today will decline in value," Hyzy says.

Frank Holmes, CEO and chief investment officer at U.S. Global Investors, a San Antonio-based investment fund, bases the case for investing in gold on the "fear trade" and "love trade."

Fear of the unthinkable

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The fear angle has to do with U.S. fiscal and monetary policies, with the argument being that high federal deficit spending combined with the Federal Reserve keeping interest rates near zero makes gold an attractive alternative to investments that don't keep up with inflation as measured by the consumer price index, or CPI, he says.

"Whenever a government offers negative real interest rates -- that's what you're earning on rates, take away the CPI number -- you have deficit spending without fiscal cutting. Gold rises in that country's currency," Holmes says.

On the flip side, if interest rates were 2 percent higher than the inflation rate or more, it would portend a drop in gold prices.

For example, Hyzy says gold's rise in the past has been driven by fear of the unknown and the unthinkable. The unknown was whether the U.S. dollar would weaken. The unthinkable was whether the world's major economies would suffer another near-catastrophic financial crisis.

24-karat love

The "love" aspect has to do with the rising demand for gold jewelry and ornaments in China, India and other emerging-market countries where gold is an important cultural symbol, Holmes says.

"Fifty percent of the world's population believes in gold ... for love, romances, birthdays," he says. "This is the Year of the Rabbit, so if you're in Asia, you can see 24-karat gold rabbits that are given as a gift."

India and China together account for a majority of the total worldwide demand for gold bars, coins and jewelry. In 2014, China overtook India as the world's leading consumer of gold, with both countries seeing a resurgence in gold jewelry, according to the World Gold Council, an industry market development organization based in London.

Globally, demand for gold softened a little in 2014, according to the World Gold Council, with jewelry and investment up slightly over 2013. Investors shied away, due to the previous year's surge in demand, according to a third-quarter review by the council.

These demand pressures might be expected to attract new supply, bringing gold prices down to Earth. But Holmes says the low-hanging fruit of gold mining already has been harvested, and environmental regulations have raised the cost of exploration, extraction and shipping.

"It's much more difficult to get that asset out of the ground," he says.

Speculators cause price swings

Generally, gold prices can be quite volatile. In fact, Holmes says that 70 percent of the time, it's a "nonevent" for the price of gold to rise or fall 15 percent in a 12-month period. In other words, investors can expect annual price swings of that magnitude or more much of the time. Gold stocks can experience even greater volatility than futures.

Some of that dramatic rising and falling is because of the involvement of central banks and speculative traders in the gold markets. That can mean positive or negative volatility for investors, depending on whether those banks and traders are buying or selling.

"Since the primary use of gold in an (investment) portfolio is as a hedge, it's important to think like a central banker. The more growth comes from areas of the world that have high savings, the more (the price of) gold is likely to continue to rise because those savings need to be put to work in nondollar instruments, which include gold and other hard assets," Hyzy says.

Gold as part of your portfolio

Holmes believes conservative investors should have 10 percent of their portfolio in gold and aggressive investors might want as much as 20 to 30 percent in this precious metal.

Hyzy isn't sold on that proposition. He says there's no hard evidence that individual investors own that much gold, and most people shouldn't have a big chunk of their wealth in any one company or commodity.

"You still have to understand that you shouldn't own too much of any one thing," he says.

Copyright 2015, Bankrate Inc.