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The Pros And Cons Of Investing in Gold

Updated 16 Jun 2022
Pros And Cons Of Trading Gold

Gold is one of the oldest assets known to man and its enduring appeal as a safe haven often results in traders and investors considering taking a position in the market whenever levels of geopolitical risk pick up.

 

Whether you’re looking to take a short-term position in gold or are a long-term investor looking to diversify your portfolio, the gold market has some distinctive characteristics that are worth factoring in. These relate not only to how price typically moves but how to ensure the method you use to hold your gold position is the best fit for you. This article will consider the pros and cons of investing in gold and then outline the steps to do so in a safe and cost-effective manner.

Who Buys Gold?

There’s an old adage in the financial markets that every investor should hold a percentage of their portfolio in gold. The thinking behind this is that gold can go up in value when certain if infrequent market conditions prevail. One twist to this strategy is that if that happens, it’s likely that all other higher risk assets will fall in value. Few would suggest going all-in on gold, but many experienced investors use it to diversify their portfolio.

Gold Price Chart – 2002 – 2022

Source: IG

Gold is seen as a form of insurance against the most dramatic of market meltdowns – those when the financial system comes under so much stress that even the viability of fiat currencies begins to be questioned. The financial crisis of 2008 was one such instance, and concern about bank defaults and the financial system resulted in gold increasing in value by 158% between March 2008 and September 2011.

Even subtle shifts in the perception of risk will trigger moves in the price of gold. As a result, certain groups of investors are known to be active in the market.

Investment Funds & Retail Investors

With billions, if not trillions of capital invested in equities, bonds, currencies and forex, large institutional investors also take positions in gold as a means of protecting themselves from any downturns in more risk-on assets.

While retail investors might not necessarily have portfolios that are the same size as the big funds, some still use gold to diversify their portfolio and hedge against risk. In 2020, 46.64% of global demand for gold was credited to being associated with investing. Other retail investors trade the commodity on a short-term basis to take advantage of the sharp price moves that can be associated with the market.

Jewellery

Demand for gold from the jewellery sector amounted to 36.83% in 2020. While there is some value added during the production process, gold as jewellery is often considered to represent demand from people investing in it as an asset.

Central Banks

Gold is recognised by the international banking system and central banking community as a monetary reserve asset. This dates back to times of the Gold Standard when fiat currency was based on a central bank’s holdings of gold. Even though the direct link between paper notes and the metal has been broken, it’s estimated that the US central bank still holds 8,133 tonnes of gold, and the International Monetary Fund (IMF) 2,814 tonnes.

Central banks have huge stores of existing gold, but ongoing demand from this group in 2020 amounted to only 8.58% of global production.

Industry

Gold is virtually indestructible and highly unreactive. As a result, it is used in industrial manufacturing processes – especially the electronics sector. In 2020 this sector made up 7.95% of the global demand for gold.

Characteristics of the Gold Market

There are certain features of the gold market that mark it out compared to other financial instruments.

Gold Supply Is Inelastic

It’s estimated that it takes more than 10 years to get a new gold mine up and running. As a result, short-term changes in demand for gold are not easily met by efforts to increase supply. This explains why price moves can be sudden and dramatic.

Gold Price Drivers Compared to Other Precious Metals

Gold is differentiated from platinum, palladium, and silver by the extent to which demand for the gold is largely based on investors looking for a store of wealth. This is in contrast to other precious metals, which due to their unique characteristics, are used extensively in manufacturing processes. Close to half of the global platinum produced in 2020 was, for example, bought by auto manufacturers who use the metal to reduce emission levels from their vehicles.

Whereas silver, platinum and palladium are categorised as precious metals, it is gold that dominates the sector in terms of being seen as a financial instrument.

Who Produces Gold?

Gold production is diversified to a greater level than some other precious metals. In 2020, China took the top spot and was responsible for 11% of global production. The amount of gold that comes onto the market after being recycled rather than mined currently equates to 25% of total annual production. As a result, no single country dominates the production of the metal.

The Different Ways of Investing in Gold

Understanding the nature of the supply and demand of gold can help investors take a view on whether the price is going to go up or down. Developing strategies that use fundamental and technical analysis can also help tip the scales in your favour. There is then the decision of which method suits you best.

Buying Gold in Physical Form

This is the oldest means of buying gold as an investment. Physical gold can be bought as bullion or jewellery and one major advantage of this approach is that the owner can literally hold it. Taking the extreme scenario of the global economy going into meltdown, ease of access would be paramount. Some investors even avoid holding bullion at banks or specialist exchanges – the reasoning being that they’d still be relying on a third party to gain access to their asset.

Keeping gold at home is an improvement in terms of guaranteeing access, but that approach comes with its own obvious security issues. Choosing to buy gold jewellery can also have its downsides – gold in this form can be subject to wide bid-offer spreads due to jewellery, to some extent, involving personal taste.

Buying Gold Futures

Futures markets allow the holder of a gold future to take delivery of the metal at a specified future date. In the build up to that expiry date, the value of the future will fluctuate as buyers and sellers take a view on what direction price.

Gold futures on specialist metal exchanges have traditionally been something for more experienced investors to consider, which can be considered somewhat of a disadvantage for investors new to the sector. There are certain protocols such as providing ‘initial margin’, meeting ‘margin calls’ and ‘rollovers’ to consider. However, the volume of gold traded does ensure pricing is efficient and bid-offer spreads are tight.

Buying Gold CFDs

Contracts for Difference (CFDs) are a more user-friendly way for beginners to trade the price of gold. CFDs are an agreement between a broker and their client where one of the parties pays the other according to how the price of gold moves.

If you buy a gold CFD at $18,000 and the price in the market goes to $18,150 then your profit will be $150. CFDs also allow you to sell short. That $18,000 trade could have been a ‘sell’ where the broker would pay the client if price fell.

CFD trading requires clients to deposit funds in an account to ensure the broker isn’t exposed to them or any losses incurred.

Prices on CFD platforms will most likely be based on data feeds from the specialist exchanges where futures are being traded. This way, clients still get full exposure to the heart of the gold market, it’s just that the broker acts as a convenient interface.

Another neat feature of CFD trading is that the broker may offer leverage, which allows clients to scale up on their risk return. One potential downside of CFD trading is that there is a possibility that daily financing fees may be incurred. These can eat into profits if positions are held for a considerable period of time. Our article on the pros and cons of CFDs looks into this in more detail.

Trading Gold Stocks

If you’re new to investing and find stepping into the commodity markets and trading metals directly is a step too far, then it is possible to gain exposure to the gold market by buying shares of firms in the sector.

This is a tried and tested approach used by large-scale investment funds who might think the price of gold is going to rise but who have an investment mandate that forbids trading in metals. They indirectly gain exposure to the gold market by buying gold mining stocks instead.

Mining stock prices tend to be highly correlated to the price of the underlying metal that they source, extract, and process. There is potential for firms that are capable of working around the obstacles posed by inelasticity of supply. It can be possible for them to squeeze extra production out of their existing operations to do particularly well in bull markets.

Rio Tinto PLC Share Price 2003–2022 – Exposure to the gold market through buying equities

rio tinto 2003 2022 exposure to gold market

Source: IG

Rio Tinto PLC is one such global mining giant that mines and refines gold and other metals. Rio is listed on the London Stock Exchange, which means it has to comply with rules and regulations of the exchange – designed to ensure investor interests are protected. It’s also often identified as being one of the best starter stocks for beginners.

Trading volumes in equities are huge, so the bid-offer spread on trades are tight enough to allow for cost-effective trading. If you buy stocks outright using a share dealing service, it’s also possible to avoid the financing costs associated with CFDs.

Returns from gold mining stocks can take two forms. The first relates to the fact that mining firms are also known for income stocks. Rio Tinto’s annual dividend yield is currently calculated to be 10.56%, which means investors can receive an annual return on their investment that is in excess of bank cash savings rates. At the same time, it’s possible to hope for capital gains generated by the share price going up.

Rio Tinto PLC – Fundamentals

rio tinto plc fundamentals gold

Source: IG

How to Buy Gold

Like all financial instruments, nothing is ever guaranteed in the gold market, but if you’re concerned that geopolitical risk could be about to go off the scale, then it is relatively easy to buy gold in a way that suits you.

It takes only a matter of minutes to open an account with a regulated online broker. The functionality of the platforms has been designed to help beginners put on their first trades, and most good brokers offer gold CFDs, stock CFDs and also a share dealing service. Buying gold in its physical form or as gold futures is another option, but both of those approaches have unique drawbacks and might not appeal to someone looking to get set up as soon as possible to take advantage of price rises that could be just around the corner.

Setting up an account with an online broker requires some form-filling and the wiring of funds using a bank card, wire transfer, or ePayment system. Once done, buying and selling gold or gold related assets is as easy as clicking a button or tapping a screen. The platforms support traders who want to trade from their desktop or on the move using a mobile phone app. If you choose a broker that is well-regulated, you’ll be taking a step towards buying gold safely.

Investors are advised to choose their broker with care. Navigate to the AskTraders list of trusted brokers, which includes CFD trading platforms that have been reviewed and checked for their trustworthiness. Alternatively, investors can gain exposure to the gold market by exploring and buying shares of firms that are operating in this commodity sector.