The Gold Standard

Gold is attracting attention from investors, with prices up from $350 per ounce in May 2003 to more than $650 per ounce in early 2007. As prices rise, …

Gold is attracting attention from investors, with prices up from $350 per ounce in May 2003 to more than $650 per ounce in early 2007. As prices rise, more and more investors are wondering how, if and when to jump in. Global trends appear favorable for gold, but too much attention could be problematic.

Rising demand

Gold is especially attractive in times of economic and political crisis. As the most widely accepted global currency, gold is viewed as a source of stability in times of currency inflation, stock market uncertainty and political conflict.

International demand for gold has also increased in recent years and shows no signs of slowing. Many emerging economies are seeking gold to build up their currency reserves. China, India and Russia are seeking gold as a reserve and also for individual collections in the form of jewelry and gifts.

Demand for gold in the Middle East has increased in response to recent political conflicts with and alienation from the U.S. Many investors are diversifying assets out of dollars and into gold and alternate currencies, such as the Euro. Some countries are losing faith in the U.S. dollar and seeking protection through diversification.

In the past, major trading nations attempted to ensure the soundness of their currencies by adhering to a “gold standard.” This meant that a dollar, for example, was equal to and could be exchanged for a specific weight in gold.

In 1973, the U.S. officially ended its adherence to a gold exchange standard, according to the Federal Reserve’s website. At that time, the U.S. and many other nations shifted to “fiat” currency systems where currency is created by a government and accepted on trust rather than backing in hard assets.

The danger with fiat currency is that nations may lose discretion and print too much currency or allow too much credit, devaluing the currency and causing inflation. Gold serves as a bulwark against a dropping dollar and other fiat currencies in part because it can’t be produced at will.

Even as global demand has increased, gold mining efforts have actually decreased production because of a decreasing supply of easily accessible reserves. Limitations in the global supply of gold ensure its precious nature.

Volatility

Gold is a volatile investment—three times more so than the stock market, according to CNNMoney’s Walter Updegrave. A limited and relatively small global supply and small market share mean that small changes can have a big impact on gold prices. One big seller getting out of the gold market can flood the market with gold; likewise, increased demand can easily drive up prices. The emotional aspect of many gold investments add to its volatility.

Although gold is a risky investment on its own, it can be useful as part of an overall portfolio. Gold prices have the advantage of independence from correlation with stock market prices, and gold investments can help offset the risks of a portfolio heavy in stocks and bonds. Gold hedges against the possibility of interest rates moving against one’s bond investments and protects against the devaluation of one’s primary currency.

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Gold investments are not the only way to achieve portfolio diversification or to hedge against market changes. Other commodities, such as silver, timber and oil, have increased in popularity for some of the same reasons that gold has in recent years. Many experts recommend that precious metals make up no more than 5 to 10 percent of a portfolio.

Ways to invest

Gold’s “spot price”—the value per ounce—is generally quoted on gold price charts in terms of U.S. dollars. When the price is displayed in other currencies, it has been converted between U.S. dollars and the local currency.

In some cases, the IRS considers gold a collectible. Since collectibles are taxed at a higher rate than standard investments, gold investors should carefully research tax consequences in advance.

Detailed information about ways to invest can be found at the World Gold Council’s website. A few of the most popular options follow.

Direct ownership

Investors can purchase gold bars, bullion or collector coins. Bars are the cheapest of the three, but they are also the most limiting. A bar of gold can be hard to sell because it comes in one large chunk that can’t be easily divided up.

Bullion coins are easier to buy and sell in smaller increments. Investors pay a small premium over the standard spot price for that flexibility. Krugerrands and British Sovereigns are the most common bullion types.

Collector coins are also available, but they are not classified as investments in the traditional sense. They trade at a higher premium and have the added risk of collector demand, which can shift quickly.

Direct gold owners usually entrust their gold to an institution for protection, which generates storage and insurance costs. Investors who want outright ownership without those fees may consider digital gold currency or e-gold dealers. These dealers allow investors to electronically buy and sell fine gold in quantities of one gram or more. This emerging sector is not required to operate according to bank regulations, so investors should be careful in such dealings.

Mining stocks, stock options and mutual funds

Investors who want to profit from gold price increases but who are not interested in direct ownership can purchase stocks in gold mining companies. This is a higher risk opportunity, since company stock prices swing both higher and lower than spot gold prices.

Mining stock risk factors include the political climate of the countries that house the mines, extraction expenses and the accuracy of projected quantities in deposits.

Stock options allow more daring investors to speculate on gold mining stock market movement. Gold stock options provide extensive leverage but can also expire worthless, so this is not a strategy for the fainthearted.

Mutual funds that invest in multiple gold mining companies enable investors to gain exposure to gold stock with reduced risk and greater diversification.

Futures

Gold futures are another high risk, high reward opportunity for daring investors. They require firm commitments to make or take delivery of a specified quantity and quality of gold at a prescribed date and price.

Investors can take possession on maturity, although that is unusual. Contracts are traded on margin, so only a small fraction of the cost is paid up front. This means excellent leverage as well as high volatility. Futures are mostly the province of institutions and hedge funds; they are not for novices.

Exchange Traded Funds (ETFs)

ETFs are a recent introduction to the gold market. Most track the price of gold bullion; a small number of extremely volatile ETFs track gold mining stocks. ETF investors don’t own the underlying gold, so there are no storage or insurance fees. ETFs generally have a 0.4 or 0.5 percent administrative fee.

Future outlook

The burning question for investors considering gold is: Will prices continue to rise? Experts are divided in their predictions.

Some argue that gold has room to grow, citing as evidence prices of $850 per ounce in the 1980s. When adjusted for inflation, this works out to more than $2,000 per ounce in today’s dollars. Others think that gold is near its peak and will soon drop.

In any case, investors who put large percentages of their portfolios into gold are making a risky decision. Those who put a small percentage into gold as a portfolio counterweight are less vulnerable to its volatility and can benefit from the more balanced portfolio it provides.

Update:  In autumn of 2007, Jacksonville-based EverBank introduced their MarketSafe CD, a certificate of deposit which negates some of the volatility that makes investors wary of the precious metals market.  The Market Safe Gold CD guarantees that the principal investment be returned at the end of a five-year period while still allowing investors to benefit from market upswings. Read more in our article Investing in Gold CDs.

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