In times of great volatility in the stock and bond markets, interest spikes up in commodities such as gold.
Since the global economic turmoil began more than four years ago, gold has had quite a run. As of Dec. 7, the year-to-date return was 9.76 percent; the three-year annualized return was 17.62 percent, and the five-year was 16.25 percent.
It’s hard to say if or how long gold can sustain its upward march. Bill Gross, co-chief investment officer of the giant money management firm PIMCO, opined in September that gold would outperform stocks and bonds over the next few years. He is a large holder of the SPDR Gold Trust ETF (GLD), which he purchases for PIMCO’s Commodity Real Return Strategy funds. (Disclosure note: I have held one of these funds for several years as a small part of my portfolio.) On the other hand, the price of gold has fallen about 5 percent from its October highs.
I believe that some investment in commodities is prudent to protect against inflation. However, I do not recommend that investors, especially retirees, invest a high percentage of their portfolio in commodities. Commodity prices are volatile, and you will not be earning income. Personally, I have restricted my investment in commodities to a maximum of 5 percent, a good rule of thumb for most investors.
If you do invest in commodities, it is important to understand the fundamental factors that affect their prices. For those interested in gold, I recommend reading All About Investing in Gold (McGraw Hill, 2011) by John Jagerson and S. Wade Hansen.
The authors examine five fundamental factors that affect gold prices: inflation, currency fluctuations, global risk discounting, interest rates, and gold supply and demand.
Here’s more on these factors:
• Inflation: There has not been a strong long-term correlation between inflation and gold prices. The authors believe that there are two fundamental reasons. First, gold is not consumed like other products, and accordingly it responds to purchasing power differently. Secondly, gold must compete for yields when an economy is growing, which is often when inflation is at its highest. If inflation occurs during a period of growth, confidence is likely to be high, which will make gold a relatively unattractive investment. If inflation is very high during a period of low confidence and high levels of fear, you should expect gold prices to increase very quickly. The bottom line is that inflation is a factor, but not just any kind of inflation will do.
• Currency fluctuations: Exchange rate fluctuations reliably affect the long-term value of gold. When the dollar is weakening against other major currencies, gold prices should be rising. If inflation is higher outside the United States, however, we may see a flight into U.S. dollar-denominated assets, creating a stronger dollar, which could inhibit gold prices.
• Global risk discounting: War, or the threat of war, is the most significant source of uncertainty for investors. Gold is seen as a safe haven investment and tends to do well when investors are most fearful. War is also associated with other factors that will drive up prices, including excess spending, money printing and political instability.
• Interest rates: Individual investors should not expect to earn income from gold investments. Accordingly, gold prices will be sensitive to alternatives that offer income, such as bonds and dividend-yielding stocks. Higher yields on bonds will have a bearish effect on gold prices, especially when the economy is good.
• Gold supply and demand: Overall, Jagerson and Hansen feel that in the near future there will be a net increase in demand over supply. However, they point out that a good gold investor will be aware of potential changes on both the supply and demand sides of the gold market.
Investors must be wary of gold scams. There are relatively safe and straightforward ways to buy gold. Jagerson and Hansen point out that the characteristics of good investment products are more or less universal: low cost, liquidity and efficiency. The authors discuss the following options: exchange-traded funds (ETFs), especially ones that hold bullion, gold-mining stocks and stock options.
Bullion ETFs are convenient, liquid and efficient. Most are passively managed or indexed and come very close to matching the index or underlying asset they are following. Fees are as low as 0.25 percent per year.
Gold ETFs are set up to minimize your tax liability. You pay taxes on your gains when you sell, not when managers make adjustments in holdings. You can hold them in tax-sheltered accounts.
Jagerson and Hansen recommend two gold bullion ETFs: GLD and the iShares Gold Trust ETF (IAU). GLD is the largest physically backed gold exchange traded fund in the world.
Remember, the price of gold, as with most commodities, is very volatile. It is a hedge against high inflation, and it provides protection against central banks printing too much money. It is not a substitute for a diversified portfolio.
Elliot Raphaelson can be contacted by email at email@example.com.