Why You Shouldn’t Be Buying Gold Blindly

It wasn’t that long ago that many investors couldn’t get enough of gold as an investment. They were buying the coins from the vending machines, the “paper” gold, the exchange traded funds (ETFs) and so on. It was everyone’s favorite default investment option.

That shouldn’t come as a surprise. Gold’s easy to understand, there was a lack of trust in a post-financial crisis stock market, and the yellow commodity was showing stellar upward price movements.

But after hitting an all-time high in 2011, we’ve seen the price plummet by over 40% and prove that gold’s not the one-way bet that a lot of people new to investing probably had assumed.

Plenty of people made a lot of money out of the gold boom, though not always the people that were investing in it. There were the books, the seminars and the trading strategies that individuals were happy to pump their money into. Generally, they had the same underlying theme – the only way is up.

How times change.

gold

The key message here isn’t that people should have completely ignored gold as an investment. It can have a role.

No, the point is that before buying any investment people should understand what they’re actually buying and why they’re buying it.

They need to understand how buying gold adds or takes away any risks. In other words, it’s not about whether it’s right to buy an investment. It’s about whether that investment’s right for YOU.

If we look at gold as a broad investment theme (and don’t specifically focus on physical gold, gold stocks and so on), what are the pros and cons of you buying it?

Pros of Buying Gold

When the world goes bad, it offers protection. When we see severe difficulties in the economic or financial environment, similar to what we saw on the back of the global financial crisis, interest in gold spikes. This is because historically the lump of metal retains its intrinsic value. Because of that investors tend to use it as a protective measure for their overall investments.

When you expect high inflation, gold is attractive. Again, gold tends to be a popular destination when you’re scared you’ll lose some of the purchasing power of your wallet.

Increasing demand from emerging markets. According to the World Gold Council, demand in China is expected to rise about 25% between 2014 and 2017. Importantly, in 2013 China overtook India as the largest user of gold in the world. So the long-term demand story from emerging markets, and China, in particular, is positive.

It offers good diversification for an investment portfolio. An important principle in managing your money is to not have all your eggs in one basket. Diversification is a way in which you can spread your risk. You don’t put all your money into one investment and risk losing it all if things go wrong. Gold can act as a useful way to diversify your portfolio. For example, one reason why gold works well for diversification is because its price tends not to move in line with the stock market.

Cons of Buying Gold

It’s only about capital appreciation. Unlike stocks, bonds or rental property, you cannot hope to receive any income from gold. You could be hanging onto your gold for years and years, but it wouldn’t give you any dividends, coupons or rental income. So if the gold price doesn’t go up, you don’t earn anything.

When interest rates rise, gold loses its appeal. Because gold doesn’t give you any income, a lot of investors are more interested when interest rates rise in finding investments that can offer them cash. Even boring bank deposit accounts start to look more appealing when interest rates go up.

The end of “easy money” means less interest in gold. It’s quite a complicated subject but quantitative easing (QE) has to get a mention here. It was a program that central banks implemented after the global financial crisis that helped support demand for gold.

QE basically was a way for the authorities to pump loads more money into the system to help stimulate economies around the world. What’s bad for the world tends to be good for gold. But programs are gradually being unwound around the world. As the global economy improves (admittedly, it’s still a bit of a slower burner), interest in gold has started to wane.

Gold prices can be more volatile than a lot of people realized. An increasing amount of speculators have been attracted to gold and price movements have become more volatile than the old days. In other words, the stability that gold used to offer isn’t as obvious as before.

Take a Balanced Approach

Many people are sitting on large losing positions in gold. This is because they didn’t understand what was driving the strong price rises in the first place. Some of the performance in the run up to the 2011 peak was down to bad world conditions, fear that things could get worse or simply down to speculative interest.

Although it’s very hard to argue that the world is on a strong growth path right now, the most extreme conditions that supported the strong price rises have disappeared.

So if you shouldn’t be buying gold as an investment solely for capital appreciation, why should you be buying it? View gold as a hedge – that is, have it as an offset to potential losses in other investments. It’s an insurance policy as part of your personal finance strategy.

Remember that money management is as much about risk management as it is about the hunt for returns. Having a bit of gold within your portfolio is always a useful way to keep some balance. It’s there to provide some comfort when the world next starts to crumble before our eyes and stock markets collapse in unison. And, yep, we will see times like that again in the future…

Share Button