There are plenty of reasons investors might want to allocate a portion of their portfolio to gold. Maybe they're worried about inflation or the enduring value of the U.S. dollar. Maybe they want an investment that doesn't behave like stocks or bonds. Maybe they want to build a tractor beam, hold the world ransom, and thwart Austin Powers once and for all.
Whatever their reasons, investors in the sparkly stuff have had an excellent year. The price of gold has risen 25.5% so far in 2020, nearly keeping pace with the tech-stock-heavy Nasdaq, and crushing the 6% return in the S&P 500.
The return includes a 7% decline in the price of gold from its August high.
You may be wondering whether it's worth buying the precious metal on the dip. To answer that question, it helps to understand what drives gold prices and the gold's track record of doing what investors want it to do, the interference of foppish British spies notwithstanding.
- It's a store of value. Gold has been currency for thousands of years. People who are worried that the world is coming to an end or that their dollars will become worthless buy gold in the knowledge that it will always have worth. "When the proverbial excrement hits the fan, the perception is that gold is one of the few stores of value," says Dmitriy Katsnelson, deputy chief investment officer at Wealthspire Advisors. For this reason, investors tend to pile into gold if they see geopolitical turmoil on the horizon.
- Gold becomes more attractive when wealth-preserving alternatives don't yield anything. Investors tend to gravitate toward gold when interest rates hit rock bottom. Currently, yields on government bonds and short-term cash accounts are failing to keep up with the rate on inflation. "If you're losing 1% annually investing in treasuries, and gold rises alongside inflation, you're presumably doing better with gold," says Jason Draho, U.S. head of asset allocation, Americas, for UBS Global Wealth Management.
- It's a hedge against inflation. Investors who expect inflation to rise buy gold on the theory that its value will rise along with the cost of goods and services. Theoretically, the rising value of gold in your portfolio can offset the diminishing buying power of your greenbacks if inflation spikes. Gold's actual record on this is iffy, though. In overlapping 12-month periods between December 1973 and May 2020, the price of gold rose faster than inflation only 51% of the time, according to data from Fidelity.
- It diversifies your returns. Unlike stock prices, which largely move based on underlying fundamentals such as corporate earnings growth, or bonds prices, which are sensitive to movements in interest rates, movements in gold prices are driven purely by investor sentiment. "The big attraction with gold is diversification. Its movements aren't well correlated to stocks and bonds. It's an asset class by itself," says Brian Cayon, chief investment officer at Waukesha State Bank Wealth Management.
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Given those reasons, it's not hard to suss out the mechanics behind gold's huge run this year and the recent pullback. Low interest rates should get a lot of credit for the run-up, says Draho, and a slight uptick in Treasury yields is at least partly responsible for the recent decline.
The unprecedented government stimulus package raised inflation concerns among investors, since pumping money into the economy is thought to be inflationary. The president's tweet throwing the timing of a second stimulus into doubt has tempered inflation concerns, for now.
If you're the doomsday prepper type, you may want to own physical gold in a vault or safe deposit box or sock drawer. But for people who want to own gold as part of their investment strategy, forget buying actual bullion, which is heavy, expensive to store, costly to transact in, and difficult to sell, says Cayon.
He and Katsnelson don't recommend much more than a 5% allocation to gold for long-term investors who view the metal as a portfolio diversifier. If you're interested in adding some shine to your portfolio, the easiest and cheapest way to buy is through an exchange-traded fund. Both iShares Gold Trust (IAU) and SPDR Gold Shares (GLD) hold actual gold in vaults and shares of the ETFs accurately track the price.
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Investors bullish on gold's prospects can get exposure through buying stocks in gold mining companies as well. Warren Buffett, the Oracle of Omaha himself, now counts himself among their fans, having disclosed a purchase of shares in Canadian miner Barrick Gold in August.
Because miners have relatively fixed costs, bumps in gold prices are theoretically passed right through to the bottom line. But buying miners introduces a new level of volatility, says Draho. "You're not only taking a risk with the price of gold, but also with the companies themselves, their operations, their management teams and the quality of specific mines," he says.
Investors can get exposure to a broad basket of mining companies through ETFs such as the VanEck Vectors Gold Miners ETF (GDX), which holds 53 stocks, weighted by market capitalization.
Investors interested in tangential plays on gold can invest in firms who make industrial equipment used for mining or companies that lease land to mining firms, "but at that point, you should ask yourself what your gold investment is for," says Katsnelson. Such firms are likely to move more like stocks, and less like gold, and if you're in gold for the diversification, it's probably best to stick with bullion or the ETFs, he says.
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