investing

The pros and cons of investing in gold

Stack of gold bars
Highlights
  • Gold is often bought as a hedge against the risk of investment losses.
  • Gold prices are more volatile than many individual investors expect.
  • Day trading by central banks and speculators can affect the price of gold.

Up, up and up. That appears to be the direction of U.S. gold futures, which hit a record high of $1,910 per ounce in mid-August on the New York Commodity Exchange, or COMEX.

The opportunity to buy might tempt investors looking for fatter returns than they've earned on certificates of deposit, bank accounts, stocks or bonds. Yet, gold is far from foolproof.

Indeed, gold shouldn't be considered an investment, says Chris Hyzy, chief investment officer at U.S. Trust, the private wealth management arm of Bank of America in New York. Rather, the precious metal acts as a hedge, or a way to try to protect wealth against the risk of loss in such asset classes as real estate, equities and bonds, he says.

Traditionally, investing in gold has been used as a hedge against inflation. That thinking still holds, though worries over inflation might be better understood as a fear of the loss of purchasing power or that "the money we currently have today will decline in value," Hyzy says.

Fear of the unthinkable

Frank Holmes, CEO and chief investment officer at U.S. Global Investors, a San Antonio-based investment fund, bases the case for investing in gold on the "fear trade" and "love trade."

The fear angle has to do with U.S. fiscal and monetary policies, with the argument being that high federal deficit spending combined with the Federal Reserve keeping interest rates near zero makes gold an attractive alternative to investments that don't keep up with inflation as measured by the consumer price index, or CPI, he says.

"Whenever a government offers negative real interest rates -- that's what you're earning on rates, take away the CPI number -- you have deficit spending without fiscal cutting, gold rises in that country's currency," Holmes says.

On the flip side, if interest rates were 2 percent higher than the inflation rate or more, it would portend a drop in gold prices.

Hyzy says gold's rise has been driven by fear of the unknown and the unthinkable. The unknown is whether the U.S. dollar will continue to weaken, due in part to Standard & Poor's downgrade of U.S. government debt. The unthinkable is whether the world's major economies will suffer another near-catastrophic financial crisis.

"Those two things are accelerating the fear, and there's no other hedge that's as clean as gold," Hyzy says.

24-karat rabbits

The "love" aspect has to do with the rising demand for gold jewelry and ornaments in China, India and other emerging-market countries where gold is an important cultural symbol, Holmes says.

"Fifty percent of the world's population believes in gold … for love, romances, birthdays," he says. "This is the Year of the Rabbit, so if you're in Asia, you can see 24-karat gold rabbits that are given as a gift."

India and China together accounted for more than half of the total worldwide demand for gold bars, coins and jewelry in the second quarter of 2011, according to the World Gold Council, an industry market development organization based in London.

These demand pressures might be expected to attract new supply, bringing gold prices down to earth. But Holmes says the low-hanging fruit of gold mining already has been harvested, and environmental regulations have raised the cost of exploration, extraction and shipping.

"It's much more difficult to get that asset out of the ground," he says.

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