The Pros and Cons of Investing in Gold


Up, up and up. That appears to be the direction of U.S. gold futures, which hit a record high of $1,910 per ounce in mid-August on the New York Commodity Exchange, or COMEX.

The opportunity to buy might tempt investors looking for fatter returns than they've earned on certificates of deposit, bank accounts, stocks or bonds. Yet, gold is far from foolproof.

Indeed, gold shouldn't be considered an investment, 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.

Fear of The Unthinkable

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."

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% higher than the inflation rate or more, it would portend a drop in gold prices.

Hyzy says gold's rise has been driven by fear of the unknown and the unthinkable. The unknown is whether the U.S. dollar will continue to weaken, due in part to Standard & Poor's downgrade of U.S. government debt. The unthinkable is whether the world's major economies will suffer another near-catastrophic financial crisis.

"Those two things are accelerating the fear, and there's no other hedge that's as clean as gold," Hyzy says.

24-Karat Rabbits

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 accounted for more than half of the total worldwide demand for gold bars, coins and jewelry in the second quarter of 2011, according to the World Gold Council, an industry market development organization based in London.

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

Gold prices can be quite volatile. In fact, Holmes says that 70% of the time, it's a "nonevent" for the price of gold to rise or fall 15% 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 due to 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.

How to Buy Gold

Investing in gold can occur in a number of ways, each subject to pros and cons. Here are four options.

  • Gold bars. Gold bars or coins can be bought through dealers, generally at a premium markup, Hyzy says. While bars have a certain cache and tactile appeal, the cost to transport, insure and securely store gold in this physical form can be steep. A standard gold bar measures 7 inches by 3 5/8 inches by 1 � inches and weighs about 400 ounces, or 27 � pounds, according to the U.S. Mint website.
  • Gold futures. Gold is traded as a commodity on several exchanges. The price, usually measured in U.S dollars per troy ounce, is set twice daily with the traditional London gold price fix as the daily benchmark, according to the World Gold Council. A futures contract is an agreement to buy or sell a set amount of a specific commodity at a stated price on a specified future date. Futures contracts can be bought and sold on exchanges.
  • Gold stocks. Investors can purchase shares in publicly traded companies involved in gold mining and related enterprises. However, these companies' fortunes don't necessarily track with the price of gold, Hyzy says. That's because the companies' stocks are affected by their own business practices, and some investors use hedging strategies to protect against gold's price volatility.
  • Gold exchange-traded funds. The easiest way to buy into gold fever is to purchase ETFs that own gold bullion. Investors should be aware that investors around the world use gold ETFs to hedge their investments or speculate on gold prices, and the ETFs themselves can be more volatile than might be expected, Hyzy says.

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