How To Invest In Gold: Key Things You Need To Know

Timo de Groot Feb 2017 - 9 min read

Investing in gold is a good way to diversify your portfolio. But how to invest in gold and what should you know before investing? We did the work for you.

Over the past 17 years, the price of gold has nearly quadrupled. It began at less than $300 in January of 2000. It ended December 2016 at close to $1200. So it’s no surprise that many investors are interested in gold.

But why has the price of gold gone up so much? Has gold gone up too far too fast? Is it about to fall? Or can you make a lot more money by investing in gold?

This article will attempt to shed some light on these questions.

Gold in the era of sound money

Once upon a time, you could exchange currency for a fixed amount of gold. Before 1933, anyone could trade a U.S. $20 bill for 1 oz. U.S. Double Eagle gold coin, for example. Savers had the right to withdraw ‘real money’ anytime they wanted.

In 1933, the U.S. government revoked the right of its residents to exchange their dollar bills for gold. But foreign citizens could still redeem them. So Americans could trade their dollars to residents of other countries in exchange for goods. These foreign dollar-holders could then trade them for gold. In this way, the dollar retained its value over time. Other countries had similar policies to maintain their currencies’ value.

During World War II, most countries spent their gold financing the war. So they couldn’t guarantee the value of their currencies anymore.

The one exception to this was the U.S. They came into the war at the end and spent way less compared to other countries. To help the world recover from the war, the U.S. agreed to redeem dollars for gold from any central bank. It did this at a rate of $35 per ounce.

As a result, many countries agreed to exchange their currencies into dollars at a fixed rate. This meant that most currencies had a stable value relative to gold.

It was an era of ‘sound money’. Inflation hardly existed, and exchange rates were stable.

In such a society, there was little need to invest in gold. Because gold has no yield. It pays no interest or dividends. And the law guaranteed the value of currencies.

The end of the era of sound money

In 1971, President Nixon shocked the world by ending the convertibility of dollars into gold.

Many economists expected this to cause the U.S. Dollar to collapse in value. After all, that is what had happened in every country that had gone off the gold standard before.

But this time, it wasn’t just one country that was suspending redemptions. It was the entire world.

It would have been reasonable to expect that all currencies would have become worthless. But as we all know, this is not what happened.

So why didn’t it?

Why currency still has value

The gold-standard was created before banking and interest rates existed. And before the discovery of oil as a source of energy.

But times have changed. And today, three factors allow currencies to keep their value.

Each country has legal-tender laws that instruct courts not to recognise gold as a payment for debts. So gold cannot be lent out or borrowed at interest. And most businesses rely on loans to pay for their short-term operating costs. So merchants generally do not accept gold as payment for goods and services.

Most countries claim that gold is a ‘collectible’ and charge hefty capital gains taxes on it. This makes transactions in gold expensive and time-consuming. Using the local currency avoids this problem.

Saudi Arabia and other OPEC countries will not accept gold in exchange for oil. To get oil from these countries, a person has to have dollars. Since these countries produce a lot of the world’s oil, this makes the dollar somewhat valuable. And it makes other currencies valuable because the dollar backs them.

Why investors need some gold instead of cash

So if currencies are maintaining some value, why do investors need gold?

There are three primary reasons why investors need to hold some gold instead of currency.

  1. 1. To avoid negative real interest rates

    When interest rates are greater than the rate of inflation, currency is usually superior to gold. This is because you can put currency into a bank account and earn interest, while this is not possible with gold. But if the interest is less than inflation, then holding currency is a losing proposition. And gold usually rises at least at the rate of inflation. So it’s usually a better option in this case.

  2. 2. To avoid rising oil prices

    If the price of oil is falling, currency is sometimes a better investment than gold. This is because oil is highly valued in the world. So you can trade it for anything. But if the price of oil is rising, then gold is usually superior to currency. You can’t print gold. It must be mined. And mining gold requires oil. So if the price of oil rises, the price of gold must rise with it.

  3. 3. Because global debt levels are high

    When governments and businesses have low levels of debt, they can survive high interest rates. But if they are deeply in debt, they need interest rates to keep falling. Otherwise, they can’t roll over their existing debts. If interest rates rise anyway, businesses go bankrupt and governments default on their debts.

For this reason, societies that have lots of debt always want central banks to keep interest rates low forever. But if inflation is high, then central banks need to raise interest rates to stop it.

This creates a catch-22 situation in which currencies mostly go down relative to gold. If the central bank raises rates, the economy crashes. Then the central bank gives in to political pressure and cuts rates again. As a result, gold rallies.

Or the central bank decides it is too politically unpopular to raise rates and never does so. Then gold rallies because the central bank didn’t raise rates.

In this kind of environment, gold is usually a better option than currency.

Gold in a diversified portfolio

The previous section gave several arguments for why gold can sometimes perform better than currency. Yet, you might wonder whether gold will perform better than stocks or bonds. Unlike currency, most stocks and bonds do pay more in income than the inflation rate.

So why not have a portfolio made up of these and forget about gold? The answer is that having some gold can protect your returns against negative events.

For example, a portfolio with a lot of treasuries in it may do well in a financial crash. It may even do better than gold in that circumstance. But if there is a lot of inflation instead, it will do poorly.

On the other hand, a portfolio of stocks may outperform gold during moderate inflation. But it will usually break even during high inflation and do poorly during a recession.

Another option is to diversify a portfolio with commodities like oil and copper. These tend to outperform both stocks and gold during times of high inflation. But they also fall hard during banking panics and recessions.

All these options are useful in a diversified portfolio. But gold is uniquely valuable because of its use as money throughout history.

Because of this use, it tends to provide stability in a variety of circumstances. When recessions happen, gold usually does better than commodities and stocks. When there’s high inflation, it tends to outperform both bojnds and stocks.  For this reason, gold can give your portfolio an added boost not easily obtained otherwise.

How to invest in gold: gold-backed ETFs

So what is the best way to invest in gold?

It used to be difficult. Before 2005, retail investors who wanted gold had to buy small coins and bars. These products were sold at a premium and were difficult to liquidate.

If an investor needed cash and wanted to sell his gold coins, he often had to ship his gold off to a coin shop in a faraway town. Then he had to wait a week or two until the gold dealer receiver and inspected the package. After this, he needed to wait for the money to be wired into his bank account.

In 2005, this problem was overcome by the creation of gold-backed exchange traded funds. Gold-backed ETFs, such as the SPDR Gold Trust (GLD), buy gold in large quantities at a low cost. They then issue shares to investors.

If the share price rises faster than the price of gold, the fund trades its shares for gold. This decreases the price of the shares and increases the price of gold.

If the share price rises slower than the price of gold, it trades gold for shares. This increases the price of the shares and decreases the price of gold.

In this way, the shares of a gold-backed ETF always track the price of gold. This allows investors to get exposure to the gold price without the hassle of buying and selling small bars and coins.

How to invest in gold: gold mining companies

Another option for investing in gold is to buy shares of gold-mining companies. These tend to give an investor leverage from the gold price.

For example, the gold price may go up by 10% while mining stocks increase by 50%. Or the gold price may fall by 10% while mining stocks go down by 50%. Whether the price of gold goes up or down, its gains or losses are usually magnified by mining stocks.

Gold-investors usually only invest in mining stocks if they’re willing to take a lot of risks. And then, they only devote a small part of their portfolio to it. Yet, it can give huge returns to those who are willing to give it a shot.

A good option for investing in gold miners is the Van Eck Vectors Gold Miners ETF (GDX). It contains a basket of stocks from the world’s largest and most successful gold miners.

Gold: past moves and future outlook

From the end of the gold-standard in 1971 until 1980, gold rose to more than 24 times the value it had been before the gold-standard ended. By then, the gold-value of the U.S. national debt had fallen to pre-WWII levels (http://pricedingold.com/us-federal-debt/). The U.S. had inflated away most of its debt to the rest of the world. It was free to start borrowing again.

Over the next 36 years, the following events shaped the price of gold:

  • In 1980, the Federal Reserve instituted “shock therapy” to stop inflation. They raised the interest rate on overnight lending (the Federal Funds Rate) to 20%. This was the highest it’s ever been in history. Gold then topped out and began to fall as inflation got under control.
  • Gold continued to fall for the next twenty years as interest rates remained high and inflation low. It bottomed at $250/ounce in 2001. Meanwhile, the debts of the U.S. government and other governments and businesses grew. And even though rates were high, they fell over time.
  • By 2002, the gold-value of the U.S. national debt had risen to 650 kilotonnes. This is the highest it’s ever been. It’s more than twice what it was in 1971. Meanwhile, the Federal Funds Rate of 1.25% had fallen below the rate of inflation of 2.4%. This was the first time the real interest rate had been negative since the 70’s.
  • From 2001-2011, oil rose to six times its previous value, from $20/barrel to $120/barrel. Meanwhile, gold rose to 7.6 times its previous value, from $250/oz. to $1900/oz.
  • From 2001-2011, the gold-value of the U.S. national debt declined to 300 kilotonnes. This was the same level it had been in 1971.
  • From 2011-2015, the Fed’s Quantitative Easing program came to an end. At the same time, new ‘shale oil’ technology started to increase the supply of oil. These events led to a falling oil price. Oil fell from $120/barrel to $30/barrel. During the same period, the inflation rate fell from 3.5% to 0%. Even though the interest rate was 0%, this still caused the “real interest rate” (the interest rate minus inflation) to rise from -3.5% to 0%.
  • From 2011-2015, gold fell from a high of $1900/ounce to a little over $1,000/ounce. Meanwhile, the gold-value of the U.S. national debt rose from 300 kilotonnes to 500 kilotonnes.
  • In 2016, the price of oil rose from $30/barrel to over $50/barrel. Inflation increased from 0% to 2.2%, and the interest-rate increased by only 0.5% This pushed the “real interest rate” into negative territory again at -1.5%.
  • From late 2015 to the end of 2016, gold rose from $1070/ounce to a little under $1200/ounce. Over the course of 2016, this was an increase of 8%.

There is no question that gold has increased substantially over the past 15 years. Even after its recent pullback, it is still four times the value that it was in 2001. But does this mean that gold is still overbought and likely to fall some more?

Is the gold bull-market over?

This set of historical facts implies that gold has room to grow. The Federal Funds Rate is only 0.5%. It’s  not the 10% or more that we would expect if the bull-market were over. The gold-value of the U.S. national debt is 500 kilotonnes. It’s not the 50 kilotonnes we would expect at the end of a debt liquidation. Inflation is only 2%. It’s not the 10% or more we would expect at the end of a gold-buying mania.

Most of the historical indicators don’t imply that gold will stop rising.

In the past few years, the falling price of oil has definitely hurt gold. So has the falling rate of inflation. But those times appear to be over. Inflation has been rising again, and the Fed is now in a catch-22 situation. It must either raise interest rates and risk a recession or else allow inflation to rage. Either circumstance is bullish for gold.

Conclusion

Since its rapid price rise over the last 17 years, many investors have become interested in gold. But has gold moved too far too fast? Probably not. Gold is useful as part of a diversified portfolio. It will most likely help investors to achieve greater returns in the future.

This article is for educational purposes only and should not be seen as financial advice.
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