Is gold a profitable investment?
Is gold a profitable investment? This is a question that investors are asking now that stock market volatility has returned, and expectations are high that inflation will rise as governments around the world inject more liquidity into the financial system.
Why invest in gold?
For a relatively small asset class, gold is getting a lot of attention. The reason is that gold has become firmly established as a kind of “anti-money,” as it is seen as the opposite of fiat currencies such as the US dollar and the euro, in addition to the limited supply of gold compared to other fiat currencies. The amount of gold “above ground” only increases by 1.5% each year, and this number is likely to decrease in the future as underground reserves decrease by up to 5% annually.
About 60% of gold demand comes from the jewelry, electrical and medical industries, and this demand is fairly stable. As for the other 40% of demand, it comes from investors and speculators. This dynamic between supply and demand means that the value of gold is stable, which makes investing in it as a hedge against inflation effective compared to investing in other financial assets.
History of investing in gold
Both gold and silver have occupied a high position in the economy since ancient times. Precious metals have always been a very obvious choice for primitive forms of money due to their scarcity and ease of transportation against other items of value, which may make us think that gold is a profitable investment.
Gold and silver remained the primary form of money until the 19th century, when the first forms of paper money appeared in Western economies, which were gold or silver receipts kept in a vault.
Silver was removed from the standard in 1873 as it was believed that too many people had access to minted silver, posing a danger to the monetary system. This resulted in the era of the gold standard.
While monetary systems evolved further during the early 20th century, most coins still represent an ounce of gold. In 1944, it was determined that the gold standard was no longer sustainable. The Bretton Woods system provided fixed exchange rates, with the US dollar pegged at $35 an ounce of gold. This effectively fixed the value of the gold, not the coins. The Bretton Woods system initially worked well, but it also became unsustainable, especially for America. In 1971 the United States withdrew from the system, effectively leading to its collapse.
Gold vs stocks and inflation
Prior to 1971, there was little point in investing in gold as the price was fixed. But during the 1970s, gold became a legitimate asset class. During this period, the inflation rate in the United States rose to more than 14%, and gold quickly became a hedge against inflation. By 1980, the price had risen to over $2,200, though it weakened significantly over the next two decades when inflation fell.
Since the 1970s, gold returns have often had a negative relationship with stock market returns. Therefore, owning gold is seen as a way to hedge against market volatility. Investing in gold is generally effective when there is speculation that central banks will increase the money supply, or when other factors lead to hyperinflation.
Investing in gold often performs well during financial crises, when geopolitical tension increases, or when war breaks out. The price of oil is closely linked to the level of inflation, and any close hostility from oil-producing countries, especially in the Middle East, could lead to an interruption in oil supplies, which would push oil prices and inflation rates higher. This is why the price of gold so often rises when geopolitical tension escalates.
If the global financial system collapses completely, the only assets that will retain their value are real assets, which may make us think that gold is a profitable investment. So far, no crisis has resulted in a complete collapse of the financial system, but every financial crisis brings us a little closer to this type of disaster. This is why gold often responds positively to any kind of global crisis, at the very least, gold can be used as a place to store wealth in times of uncertainty.
Types of gold investments
There are several ways to own gold, either in physical form or indirectly. Here are the three most common categories:
Investing directly in gold means that you own actual gold, either in the form of gold bars or rare coins. Gold bullion is bought and sold at a price close to the spot price of gold. As for rare coins and coins, the value depends on the amount of gold in each coin and on other factors such as its rarity, age, and condition. Investing in gold bars and coins presents a host of new challenges such as storage, transportation and insurance, but on the other hand, you know exactly what you own and there are no counterparty risks.
Over the past 50 years, a large number of financial products displaying gold prices have appeared. First, exchange-traded futures and options, then exchange-traded funds (ETFs) and contracts for difference (CFDs). These products allow gold to be traded electronically, which is cheaper and more efficient than investing in physical gold. But there will always be some concern that these products mean you are still somewhat exposed to the financial system.
An indirect way to buy gold is to invest in shares of a company that produces gold. You can also invest in stocks in gold mines which will enable you to earn dividends unlike any other type of gold stock, gold miners with lower production costs are usually able to pay regular dividends. Unlike marginal mines, which have high production costs and a high ability to leverage the price of gold.
Gold streaming companies are a different type of gold stock, which are companies that provide capital to gold miners in exchange for the option to buy gold from the mine at a fixed price. Gold manufacturers can diversify their risk by investing in each of these options.
What is the best way to invest in gold?
The following chart tracks the price of gold (in black) against some of the world’s largest gold miners over the past five years.
At first glance, it may seem that gold stocks are much better than investing in gold, but it is important to realize that this is a period during which the price of gold has risen by 40%. Gold mining stocks can fall as much or more when the price of gold falls. In the second half of 2016, the price of gold fell by 16%, while the share price of many of these miners fell by more than 40%.
It is also worth noting that these are the largest miners in the world, and they usually have lower production costs. In contrast, the share prices of smaller miners are usually more volatile. Gold mines present new risks and challenges such as rising costs as the mines age, plus you have to understand the industry and all the factors that affect stock prices before investing in it.
If you are investing in gold to hedge your portfolio against volatility and inflation, exposure to the price of gold itself will be more reliable. On the other hand, if you are confident that the price of gold will rise and you want to maximize returns, then gold stocks are the best option for you. Before investing in gold, it is worth understanding the pros, cons, and risks.
Reasons to invest in gold
Since it is a real asset with a limited supply, gold is an effective hedge against inflation.
Gold usually does well during recessions, bear markets, and when stock market volatility is high.
Gold does not have close relationships with most asset classes. This is a useful feature when building a diversified investment portfolio, as investing in gold can be an effective way to hedge the risks and volatility of the portfolio.
While interest rates are low, the opportunity cost of investing in gold is also low. In other words, by owning gold, you don’t miss out on high interest or dividend payments.
Gold is a tangible asset, meaning you know exactly what you own. On the other hand, the value of other financial assets is based on expectations about the future which involve uncertainty.
Reasons not to invest in gold
Unlike cash, stocks and bonds, gold does not pay any kind of return.
Since there is no return, it is impossible to calculate the intrinsic value of gold. The price of gold completely controls supply and demand, which means that its price has a speculative nature.
If you own physical gold, you need to store and move it. If you hold gold indirectly, you could run into the same liquidity problem as other financial assets in the event of a financial system crash.
For physical gold, transaction costs are higher than they would normally be for assets traded electronically. This is especially true of gold coins.
Speculation and the use of leverage create increased risks for anyone investing in gold. When you use leverage to buy an asset, it is likely that you will not be able to get out of a meaningful downturn. If there are too many speculative long positions, and those positions are leveraged, the price can drop dramatically in a short period.
Three ways to invest in gold
If you are considering investing in gold, it is important to be clear about your goals and why you are doing so. One way to do this is to split your gold investment across the following three strategies. This will allow you to spread out the risk, while exploiting all the potential benefits of gold as an investment.
Strategic asset allocation
Strategic asset allocation is designed to optimize your return to a given level of risk over the long term. Allocating a small amount of your investment portfolio to gold should reduce volatility and act as a hedge in the event of hyperinflation or a collapse of the financial system.
This investment should not be based on gold price quotation, but on gold’s low correlation with other asset classes. The returns generated from the strategic allocation of gold will depend on the price you pay. If you can buy into weakness, long-term returns are more likely to be positive.
Tactical asset allocation
The most active form of asset allocation is TAA, or Tactical Asset Allocation. This entails moving 10-20% of your portfolio to riskier assets and safe haven assets such as gold, bonds and cash.
There is no clear line between market timing and tactical asset allocation, so this strategy should be seen as a method of hedging rather than a means of generating returns. When a correction or bear market begins, no one knows how long it will last. Technical analysis is a way to protect a portfolio in the event of a prolonged market slump but may hurt performance if the correction is short-lived.
If your goal is to profit from movements in the price of gold, following trends is often easier than trying to predict the price using fundamental analysis, since it is a feature of gold that its trends are mostly static.
This means that you will have a third allotment of gold when the price goes up but exit that position when it goes down. You can use trend lines or moving averages to follow trends. You can even short gold during downtrends, although this introduces a new set of risks.
Alternatives to investing in gold
While gold can be considered a profitable investment, it is not the only precious metal that you can use to hedge against volatility and inflation. There are many investors who believe that silver is a better investment. Gold is usually a little better in terms of hedging against volatility, but both metals have their own benefits when it comes to hedging against inflation.
Hedge funds can also be used, investing in other alternative asset classes such as real estate, private equity, etc.
In the long term, stocks have outperformed gold by a wide margin, but what happens in the future will depend on the performance of companies and the economy, as well as on inflation. However, gold is likely to retain its value and it is difficult to imagine a scenario where gold investors are wiped out, making it a rather profitable investment.
Gold is also an important tool for investors because it has a very low, even negative correlation with other asset classes, and is one of the most effective hedges against volatility. Investing in gold will also pay off from inflation returns, especially if monetary policy leads to hyperinflation.
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