3 Reasons To Invest In Gold

Investing

3 Reasons To Invest In Gold

We examine the main reasons why investors continue to pour money into gold, and discover why the precious metal is such a vital component of so many investment portfolios.

Published on 28 September 2017

When gold prices hit an all-time high of US$1,917 per ounce in 2011, many analysts predicted that the precious metal was on course to rise as high as US$4,000. Of course, that didn’t happen. Instead, gold prices started trending downwards. They are currently at about US$1,300 per ounce, having lost a third of their value in the last six years. An investor who made a purchase when gold was at its peak would have incurred a substantial loss.

As with any other investment, you run the risk of losing a chunk of your capital when you invest in gold. In addition to this risk, gold investment has some other downsides. Firstly, unlike stocks and bonds, gold does not provide regular income in the form of dividends or interest. Also, gold buyers can also become the victim of cheats and con artists. If you are planning to make a purchase, it is advisable to take some basic precautions.

Does that mean that gold is a poor investment? On the contrary, every individual’s portfolio should contain at least some gold. Many financial advisors recommend that you allocate around 5% of your total portfolio to the precious metal. You can hold physical gold or buy a gold exchange-traded fund (ETF).

Here we examine how the decision to invest in gold could bolster and benefit your portfolio.

1) A hedge against inflation

Financial advisors often make the case for an investment in gold by saying that in ancient Rome, an ounce of gold was enough to pay for a citizen’s toga, his belt, and a pair of sandals. In modern times, the same quantity of gold will get you a suit, a belt, and a pair of shoes.

This oft-repeated example makes a very important point. Gold is an excellent hedge against inflation. The value of paper currency has been declining for decades.

consumer price index: purchasing power of the us dollar 
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The chart above illustrates the declining purchasing power of the US dollar. It considers 1982-84 as the base period with a consumer price index (CPI) of 100.

In January 1970, the purchasing power of the dollar stood at 264.3. At that time, an ounce of gold cost US$35. In 2017, 47 years later, the dollar’s value has slipped to a level of 40.7, a loss of 85% in its purchasing power. In the same period, gold has appreciated from US$35 to US$1,300, a 37-fold increase.

Gold can help you beat inflation even over shorter time periods. In January 2000, the dollar’s purchasing power stood at 59.2 (1982-84 = 100) and the price of gold was US$283. Seventeen years later, the dollar has lost 31% of its value with its buying power slipping from 59.2 to 40.7, while gold has appreciated 4.6 times.

2) Gold as a safe haven

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When the global economy is humming along, and global trade and gross domestic product (GDP) are growing, gold prices usually remain stagnant. But if the world’s major economies face headwinds or if there are negative geopolitical developments, investors often reshuffle their portfolios and pour money into gold, pushing up prices.

Political uncertainties almost always have a positive effect on gold prices. This week, for example, after North Korea accused US President Donald Trump of declaring war over the Asian nation’s nuclear programme, there was an immediate spike in gold prices.

Similarly, Britain’s Brexit vote caused gold prices to rise sharply. In June last year, in a surprise outcome, British voters opted to leave the European Union. Soon after the results of the referendum were announced, the sterling plunged and Europe’s biggest bourses recorded an 8% decline. At the same time, gold achieved a two-year peak gaining about 8%. Even shares of gold mining companies saw a sharp increase in prices.

3) Gold prices rise when the stock market falls

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One of the most important reasons to include gold in your investment portfolio is that it can help to cushion you from stock market losses. In fact, gold’s record high of US$1,917 in 2011 was at least partially caused by the global financial crisis of 2007-08. Investors sought safety in gold when the stock market crashed.

The current stock market boom has seen gold prices remaining largely stable. The Dow Jones Industrial Average stood at 18,094 on 26 September 2016. A year later, on 22 September 2017, it has climbed to a level of 22,349, an increase of almost 24%.

How has gold fared in this period? Predictably, it has remained at the same level. It was US$1,322 an ounce in September 2016 and is currently at about US$1,300.

However, a word of caution is in order here. Investors should remember that there is no guarantee that gold prices will fluctuate inversely with stock market valuations. While gold prices often rise when share prices fall, there may be times when the effect is minimal. But as a general rule, diversifying your investment portfolio to include gold to insulate you against downturns in the stock market is advisable.

Outlook for gold prices

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Where are gold prices headed? Nobody knows for sure, of course, but one school of thought holds the view that they will remain stable or even decline in the near-term –  as investors will opt to put their money into the stock market, which has been on a steady climb upward.

Additionally, the US Federal Reserve’s plan to continue hiking interest rates is expected to strengthen the dollar and make gold investments less attractive. With the US economy in expansion mode and stock markets on an upswing, gold prices seem unlikely to rise.

But other analysts are of the opposite view. They think that the stock market is currently overvalued. The price-earnings (P/E) ratio, which compares the current market price of a share to its yearly earnings, is abnormally high for many firms. On 22 September 2017, the P/E ratio of the NASDAQ 100 stood at 25.89. The S&P 500’s ratio was 24.25.

The experts who think that the markets are overvalued say that economic growth or even company profits do not justify current share prices. A correction or a stock market crash could take place soon –which could be caused by market fundamentals, global economic developments, or geopolitical conflict.

The bottom line

It is advisable for investors to adopt an asset allocation strategy that includes gold. Consider it as a form of insurance. If your stock investments continue to perform well, you will gain. But if share prices fall, your holdings in gold could help you mitigate the extent of your losses.

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