The beginner’s guide to investing in gold
Imagine yourself swirling water in a pan next to a stream, desperately hoping to see a small yellow glint of gold and dreaming of striking it rich. Australia has come a long way since the early 1850s, but gold still holds a prominent place in our global economy today.
Here’s a comprehensive introduction to gold, including why it’s valuable and how we obtain it, how to invest in it, the risks and benefits of each approach, and advice on where beginners should start.
Why is gold valuable?
In ancient times, gold’s malleability and lustre led to its use in jewellery and early coins. It was also hard to dig gold out of the ground. The more difficult something is to obtain, the higher it is valued.
Over time, humans began using the precious metal as a way to facilitate trade, and accumulate and store wealth. In fact, early paper currencies were generally backed by gold, with every printed note corresponding to an amount of gold held in a vault somewhere for which it could, technically, be exchanged (this rarely happened).
This approach to paper money lasted well into the 20th century. Today, modern currencies are largely fiat currencies, so the link between gold and paper money has long been broken. However, people still love the yellow metal.
Where does the demand for gold come from?
The largest demand industry, by far, is jewellery, which accounts for about 50% of gold demand. Another 40% of demand comes from direct physical investment in gold, including that used to create coins, bullion, medals, and gold bars. (Bullion is a gold bar or coin stamped with the amount of gold it contains and the gold’s purity. It is different to numismatic coins, which are collectibles that trade based on demand for the specific type of coin rather than the coin’s gold content.)
Investors in physical gold include individuals, central banks, and more recently, exchange-traded funds (ETFs) that purchase gold on behalf of others. Gold is often viewed as a ‘safe haven’ investment. If paper money were to suddenly become worthless, the world would have to fall back on something of value to facilitate trade. This is one of the reasons investors tend to push up the price of gold when financial markets are volatile.
Since gold is a good conductor of electricity, the remaining 10% of demand for gold comes from industry for uses including dentistry, heat shields, and tech gadgets.
How is the price of gold determined?
Gold is a commodity that trades based on supply and demand. The interplay between supply and demand ultimately determines what the spot price of gold is at any given time.
The demand for jewellery is fairly constant, though economic downturns can lead to a temporary reduction in demand from this industry. The demand from investors including central banks, however, tends to inversely track the economy and investor sentiment.
When investors are worried about the economy, they often buy gold, and based on the increase in demand, they push its price higher. You can keep track of gold’s ups and downs at the website of the World Gold Council, an industry trade group backed by some of the largest gold miners in the world.
How much gold is there?
Gold is actually quite plentiful in nature but it is difficult to extract. For example, seawater contains gold but in such small quantities, it would cost more to extract than the gold would be worth. So, there is a big difference between the availability of gold and how much gold there is in the world.
In early 2021, the World Gold Council estimated there were about 197,576 metric tonnes of gold above ground being used today and roughly 54,000 metric tonnes of gold that could be economically extracted from the earth using current technology. Advances in extraction methods or a materially higher gold price could shift that number. Gold has been discovered near undersea thermal vents in quantities that suggest it might be worth extracting if prices rose high enough.
How do we obtain gold?
Although panning for gold was a common practice during the Australian gold rush, nowadays it is mined from the ground. While gold can be discovered by itself, it’s far more commonly found along with other metals, including silver and copper. Thus, a miner may actually produce gold as a by-product of its other mining efforts.
Miners begin by finding a place where they believe gold is located in large enough quantities that it can be economically obtained. Then, local governments and agencies have to grant the company permission to build and operate a mine. Developing a mine is a dangerous, expensive, and time-consuming process. There is little to no economic return until the mine is finally operational, which often takes a decade or more from start to finish.
How well does gold hold its value in a downturn?
The answer depends partly on how you invest in gold, but a quick look at the gold price relative to share prices during the bear market of the 2007-2009 recession provides a telling example.
Between 30 November 2007 and 1 June 2009, the S&P/ASX 200 Index (ASX: XJO) fell almost 50%. The price of gold, on the other hand, rose 25%. This is the most recent example of a material and prolonged share market downturn, but it’s also a particularly dramatic one because at the time, there were very real concerns about the viability of the global financial system.
When capital markets are in turmoil, gold often performs relatively well as investors seek out safe haven investments.
Ways to invest in gold
Here are all the ways you can invest in gold, from owning the actual metal to investing in companies that finance gold miners.
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Gold mining shares
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Gold miner ETFs
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The mark-ups in the jewellery industry make this a bad option for investing in gold. Once you’ve bought it, its resale value is likely to fall materially. This also assumes you’re talking about gold jewellery of at least 10 karats (pure gold is 24 karats.) Extremely expensive jewellery may hold its value, but more so because it becomes a collector’s item than because of its gold content.
Bullion, bars, and coins
These are the best options for owning physical gold. However, there are mark-ups to consider. The money it takes to turn raw gold into a coin is often passed on to the end customer. Also, most coin dealers will add a mark-up to their prices to compensate them for acting as middlemen.
Perhaps the best option for most investors looking to own physical gold is to buy gold bullion directly from the Royal Australian Mint, so you know you are purchasing from a reputable dealer.
Then you have to store the gold you’ve purchased. That could mean renting a safe deposit box from the local bank, where you could be paying an ongoing cost for storage. Selling, meanwhile, can be difficult since you have to bring your gold to a dealer, who may offer you a price that’s below the current spot price.
Another way to get direct exposure to gold without physically owning it, gold certificates are notes issued by a company that owns gold. These notes are usually for unallocated gold, meaning there’s no specific gold associated with the certificate, but the company says it has enough to back all outstanding certificates. You can buy allocated gold certificates but the costs are higher.
The big problem here is that the certificates are really only as good as the company backing them, sort of like banks before the Federal Government’s Financial Claims Scheme was created.
This is why one of the most desirable options for gold certificates is the Perth Mint, which is backed by the government of Western Australia. That said, if you’re going to simply buy a paper representation of gold, you might want to consider ETFs instead.
If you don’t particularly care about holding the gold you own but you want direct exposure to the metal, then an ETF like the ETFs Metal Securities Australia Ltd is probably the way to go. This fund directly purchases gold on behalf of its shareholders. You’ll likely have to pay a commission to trade the ETF, and there will be a management fee but you’ll benefit from a liquid asset that invests directly in gold coins, bullion, and bars.
Another way to own gold indirectly, futures contracts are a highly leveraged and risky choice that is inappropriate for beginners. Even experienced investors should think twice here. Essentially, a futures contract is an agreement between a buyer and a seller to exchange a specified amount of gold at a specified future date and price.
As the gold price moves up and down, the value of the contract fluctuates, with the accounts of the seller and buyer adjusted accordingly. Futures contracts are generally traded on exchanges like the ASX, so you’d need to talk to your broker to see if it supports them.
The biggest problem: Futures contracts are usually bought with only a small fraction of the total contract cost. For example, an investor might only have to put down 20% of the full cost of the gold controlled by the contract. This creates leverage, which increases an investor’s potential gains – and losses. And since contracts have specific end dates, you can’t simply hold on to a losing position and hope it rebounds.
Futures contracts are a complex and time-consuming investment that can materially amplify gains and losses. Although they are an option, they are high risk and not recommended for beginners.
Gold mining shares
One major issue with direct investment in gold is that there’s no growth potential. An ounce of gold today will be the same ounce of gold 100 years from now. That’s one of the key reasons famed investor Warren Buffett doesn’t like gold – it is, essentially, an unproductive asset.
This is why some investors turn to gold mining shares. The share prices of gold mining companies tend to follow the gold commodity price. However, miners are also running businesses that can expand over time, so investors can also benefit from their increased production. This can provide the upside that owning physical gold never will.
However, running a business also comes with the accompanying risks. Mines don’t always produce as much gold as expected, workers sometimes go on strike, and disasters like a mine collapse or deadly gas leak can halt production and even cost lives. All in all, gold miners can perform better or worse than the gold price depending on what’s going on with that particular miner.
In addition, most gold miners produce more than just gold. That’s a function of the way gold is found in nature, as well as diversification decisions made by the mining company’s management.
If you’re looking for a diversified investment in precious and semi-precious metals, then a miner that produces more than just gold could be seen as a net positive. However, if what you really want is pure gold exposure, every ounce of a different metal that a miner pulls from the ground simply dilutes your gold exposure.
Potential investors should pay close attention to a company’s mining costs, existing mine portfolio, and expansion opportunities at both existing and new mines when deciding which gold mining shares to buy.
If you’re looking for a single investment that provides broadly diversified exposure to gold miners, then low-cost index-based ETFs like VanEck Gold Miners ETF AUD or the BetaShares Global Gold Miners ETF – Currency Hedged are good options. Their expense ratios are 0.53% and 0.57% respectively.
As you research gold ETFs, look closely at the index being tracked, paying particular attention to how it is constructed, the weighting approach, and when and how it gets rebalanced. All are important pieces of information that are easy to overlook when you assume that a simple ETF name will translate into a simple investment approach.
What’s the best way for a beginner to invest in gold?
There’s no perfect way to own gold because each option comes with trade-offs. However, what to invest in is just 1 piece of the puzzle. There are other factors that you need to consider.
How much should you invest in gold?
Gold can be a volatile investment, so you shouldn’t put a large amount of money into it. We think it’s best to keep it to less than 10% of your overall share portfolio. The real benefit, for new and experienced investors alike, comes from the diversification that gold can offer. Once you’ve built your gold position, make sure to periodically balance your portfolio so that your relative exposure to it remains the same.
When should you buy gold?
It’s best to buy small amounts over time. When the gold price is high, the prices of gold-related shares rise as well. That can mean lacklustre returns in the near term, but it doesn’t diminish the long-term benefit of holding gold to diversify your portfolio. By purchasing a little at a time, you can dollar-cost average into the position.
As with any investment, there’s no one-size-fits-all answer for how you should invest in gold. But armed with the knowledge of how the gold industry works, what each type of investment entails, and what to consider when weighing your options, you can make the decision that’s right for you.
Motley Fool contributor Sebastian Bowen owns Newcrest Mining Limited. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.
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