The Pros and Cons of Investing in Gold


As long as humans have been around, we've been fascinated by gold. It's deeply woven into our cultural history. We've also been using it as a form of currency since at least 600 A.D.

The attraction is not hard to explain. Gold is beautiful. It also has a poetic origin story. Scientists believe gold was created in a massive supernova event, and was present in the dust that formed our solar system. 

For investors, the lure of gold is much more prosaic. It's a commodity that offers security through inherent value, unlike paper money.

Yet is gold really a good investment? Or is it even an investment at all?

Let's find out.

Why investing in gold makes sense

Many observers argue that gold isn't really an investment, but a hedge. It's a great way to protect against losses in other asset classes. It's also a traditional hedge against inflation, or the concern that the money we have will lose purchasing power. 

There's also positive news of the demand front. Gold is extremely popular in China, India and other parts of the developing world. China and India are the world's two largest markets for gold, so rising demand could portend higher prices.

Increased demand sometimes depresses prices because it creates a glut. That's unlikely to occur here, however. Much like oil, some gold is relatively easy to extract and other sources are much more difficult to mine. Most of the easily mined gold has already been tapped, which should help keep prices elevated.

Gold is also an excellent "safe port in a storm" for your money. Economic turbulence and global instability don't affect gold in the same way other asset classes are affected. Many people believe resource scarcity will create massive turmoil in the decades ahead. Should this scenario occur, gold could become vastly more desirable.

Why you should avoid gold

For many investors, fear is an animating principle. The remarkable surge in gold prices of a few years ago was driven in large part by fear of looming economic trouble. Gold was trading at less than $500 an ounce in 2005. By 2011 that same ounce was worth $1,900. That's a powerful testament to fear-driven investing.

It's also an eye-bulging return. Yet, in retrospect, it appears to have been something of a bubble. Gold has since dropped to less than $1,100 an ounce. Even more worrisome, it's dropped more than $100 in the last 30 days alone.

Some observers are predicting the losses are just getting started. Claude Erb and Campbell Harvey, a commodities manager and finance professor respectively, are the authors of a rather alarming study about the short-term prospects of gold prices.

The study's formula argues that the true value of gold is somewhere in the area of $825. Erb and Campbell believe once gold starts dropping, it will overshoot this true value by a considerable margin. They predict gold could ultimately drop to $350 per ounce.

If you're heavily invested in gold, you might be tempted to write this study off as the work of cranks. Unfortunately, the pair have already been validated to some extent. The study was released in 2012. Gold has dropped $500 an ounce in the interim.

Harvey has pointed out that in 2012 the study's claims of a plunging gold market were met with ridicule. Yet history -- so far -- has borne out their conclusions.

There is a bit of good news here for gold owners. Erb and Harvey's study predicts dire things in the short-term, but is far more bullish on its long-term prospects. That long-term, however, is measured in decades rather than years.

The takeaway

Anyone who entered the gold market in 2011 has taken some lumps. It also seems likely gold prices will continue to weaken in the near term. Yet investors would be wise to remember a few things.

It's becoming more difficult to find gold deposits. When deposits are found, it's harder to extract the gold. Production may not keep up with rising demand. Gold could also be the beneficiary of stock market correction. Spooked investors will scout for alternatives. 

Today may not be the ideal time to enter the gold market in force. Yet as a classic hedge against future uncertainty, gold still retains its permanent luster.

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