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Gold Investment Advantages and Disadvantages

04 April 2018

Gold Investment Advantages and Disadvantages
Gold Investment Advantages and Disadvantages

The primary advantages of investing in gold are:
  • There is strong global market demand for gold
  • Gold is an ideal hedge for financial market risks
  • Diversification with gold offsets inflation
  • Gold is a highly liquid asset
The primary disadvantages of investing in gold are:
  • Gold appears to have no yield
  • Large amounts of bullion may incur some storage fees
  • Gold ETFs may incur brokerage fees (like shares)
  • Gold can be volatile on a short-term basis (again, like shares)

Let’s take a closer look to understand how the advantages of investing in gold outweigh the disadvantages.
 

There is worldwide demand for gold investment

Given a price rise of over USD $1,000oz since the turn of the century, it’s no surprise that investor interest in gold continues to grow worldwide. Amidst all the talk about cryptocurrencies and index funds, it’s easy to forget that the market for gold investment is truly diverse, with significant trade occurring in England, America, Germany, Hong Kong and other parts of Asia, as well as the Middle East. This global market is one of the main advantages of holding gold as an asset, because unlike holding, say shares in Facebook, which are subject to the whims of media coverage, gold may not garner all the headlines in your local market, but it carries great cultural significance worldwide. This unique status means that there is no substitute or proxy for holding physical gold bullion.
 

Why do people invest in gold?

The reasons people tend to make a gold investment are also diverse, as gold is simply ingrained in some cultures as a form of wealth and saving, whilst in other countries and for other individuals, it’s more about hedging financial market risks, as well as wanting to hedge against rising inflation.

In Western countries in particular, gold investment is driven by fears over inflation, and by investors who want to own an asset that is uncorrelated to the stock market, so that they can balance their portfolio.

Whenever interest rates fall, or more importantly, inflation rises, investors tend to look at making a gold investment, whilst a fall in the stock market also tends to lead to more buying.


Gold provides excellent liquidity

Another factor that drives gold investment is liquidity. When making an investment, the ease with which you can buy and sell an asset should be a primary concern, and with over USD $100bn in daily trade, gold investment is one of, if not the, easiest assets for everyday investors to buy and sell.


Disadvantages of gold investment

The main reasons investors may choose not to invest in gold are that, typically, gold pays no yield, there are trading and storing costs involved, and that short-term it is quite volatile. Whilst these are all reasonable concerns, they shouldn’t stop people owning some gold as part of their portfolio.
 
Whilst gold doesn’t tend to have a yield (in theory it can be lent though in practice this is difficult to do), its long-term capital gains more than offset the lack of income, with gold prices rising by circa 9% per annum over the last 45 plus years. Given the preferential tax treatment of tax gains made on capital vs. income for long-term investors, there is actually an advantage to having your gains made exclusively on the capital side.
 
The trading and storage cost for gold are also not exorbitant, and are essentially in line with some of the fees charged on other investments like managed funds.
 
Finally, whilst yes, gold is volatile in the short term (like shares), a gold investment made for the long-run tends to bear fruit, as per our earlier comment regarding the 9% long-run return. That kind of return almost matches the share market, and outperforms other traditional defensive assets like bonds and cash. 
 

Types of gold investment

Whilst nearly everyone is familiar with the idea of how to buy gold jewellery, gold investment typically comes in three main forms:
  • Physical gold bars and coins
  • Gold ETFs
  • Gold mining shares
Hedge funds and institutional investors, as well as short-term traders may also choose to make a gold investment through other vehicles like futures contracts, options and/or CFDs, but these are all securitised products and tend to involve more risk.

For the majority of investors, the first three options are the primary choices to pick from when wanting to buy gold. Each of these three forms of gold investment have their advantages, as well as their potential disadvantages.
 

Physical Gold Bars and Coins
Gold Investment Option 1 – Physical Bars and Coins

Individuals who choose to make a gold investment through physical bars and coins can be comfortable that they have full legal title to the gold they have bought.
They also have the advantage that, via this form of gold investment, they will be able to trade their gold around the clock, provided of course they are buying and selling with a reputable, accredited bullion dealer.

Over the long-run, a gold investment in bars and coins can also be the cheapest, as storage costs are either free (if stored at home), or very cheap, if the physical metal is stored in a private vault.

Unquestionably, buying physical bars and coins is the safest form of gold investment as it eliminates third party risk, which you will still have if you buy gold in securitised form for example. There is also no question that your investment will match the gold price, as that is exactly what you’ve bought, whereas other options, like a gold ETF, are meant to track the gold price but don’t always do so perfectly.
 

Gold ETFs
Gold Investment Option 2 – Gold ETFs

For some individuals, using a gold ETF makes more sense for their gold investment. The primary advantage of this form of gold investment is that it is really easy, as any investor with a brokerage account can buy a gold ETF in much the same way they buy and sell shares in their favourite listed companies.

There are however some disadvantages to this form of gold investment, the most obvious of which is that you don’t actually own gold when buying a gold ETF.

Instead, you own a security, and the security is in theory backed by physical gold, owned by a third party on your behalf.

For some people making a gold investment, this added risk is no major worry for them, but for more risk conscious investors, it is an insurmountable problem.
Ownership is not the only potential drawback to this type of gold investment, with the investors in a gold ETF limited to trading their gold in the hours that their local stock market is open, rather than the round the clock physical bullion market.

A final drawback to this type of gold investment is the long-term costs. Most gold ETFs charge a percentage funds-under-management (FUM) fee, which can range from 0.40% to 0.50%
If you put $100,000 into a gold ETF, in year 1 your fee will be $400. But if the gold price doubles over 5-10 years, then you’re fee will also double, as it is linked to the value of the gold.
This is of course different to gold investment option 1 (physical bars and coins) which can be stored either free, or at a fixed dollar cost in a vault. 
 

Gold Mining Shares
Gold Investment Option 3 – Gold Mining Shares

Arguably the most risky form of gold investment is to buy shares in gold mining companies, or companies exploring for gold.

The reason that this is the riskiest is that the companies may never actually find gold (in the case of gold explorers) or build a profitable mine.

Even the companies that are producing gold can see output fall, or costs rise, both of which can play havoc with their margins, and cause extreme volatility in the price of their shares.

In short, you aren’t really making a gold investment per se when you buy shares in a gold mining company. Instead you are buying an ownership stake in a company that is in the business of finding gold and selling it to the market at a profit (hopefully).

Note this is not to say that investing in gold mining companies can’t be a great gold investment (they can), but the point is that they are far riskier than an investment in physical gold, or a gold ETF.
 

Why the advantages of investing in gold outweigh the disadvantages

As you can see, there is more than one way to make a gold investment. The safest, and indeed cheapest gold investment over the long run is to simply buy the physical bars and coins.

For those who are OK paying higher costs over the long run, and who aren’t as concerned about the third party risks or the reduced trading flexibility, then a gold investment via an ETF can make sense, as it is typically very easy to do.

Finally, for those who are comfortable taking on more risk – an investment in a gold mining company can make sense too.

One final option to consider for gold investment is to combine options one and three.

By doing so, an individual’s gold investment is well diversified, in that they own physical bars and coins (cheapest and safest), but may also generate some higher returns if they pick the right gold mining companies too.