Will the Gold Rush Continue, or will Fool's Gold Rule?

October 28, 2009

Originally posted 10/28/2009 at FPA's All Things Financial Planning blog

Robert Schmansky, CFP(r)

 

Have you heard this one lately? “Gold has returned more than 300 percent over the last decade. How is your IRA doing?”

 

If you haven’t yet, you almost certainly will. Gold is at all time highs. Concerns about the dollar and the global “flat” currency system (in which currencies are not backed by gold as they once were) have renewed interest in protecting wealth by owning that precious metal.

 

So, the question of the day is… do you need it in your portfolio?

 

As with any investment — be it gold, stocks, bonds, mutual funds, etc. — before you jump in, you need to know the answers to these basic questions:

 

1) What is its purpose in my portfolio?

2) How will I make the investment, and at what price?

3) When will I know it’s time to sell?

 

If you haven’t already thought these questions through, the driver in your recent interest in gold is likely simply a fear of missing out, perhaps fueled by aggressive advertising by gold dealers. This is normal, but concern about missing the boat often creeps in after the ship has long since sailed.

 

So, to find out if gold is a fit for your portfolio, let’s cover the basics. First, here are some reasons that gold, as well as real estate and other “hard assets,” may be a sound part of your overall investment strategy:

 

“Store of value” (inflation protection). You work hard for your money. Gold, since the beginning of recorded history, has been used to ‘store’ the fruits of one’s labor for future consumption in a way that maintains purchasing power. However, the required holding period may be lengthy; over the last several decades, gold has not always kept pace with inflation.

 

Inflation speculation. One of the reasons for gold’s recent run-up in value is that its buyers speculate in gold not based on recent inflation rates, but on expectations of future inflation rates. During the 1970s, many people expected the period’s high inflation rates would continue well into the future. But when future inflation expectations began to drop, so did the price of gold.

 

Diversification. Gold and other commodities tend not to move in the same direction as stocks and bonds. Gold is therefore considered a portfolio diversification tool.

 

For most of us, the best place to store the fruit of our labor for our emergency needs is cold, hard cash in a federally insured bank which is available when you need it, in a predictable amount. Gold must be considered more of an investment than a cash equivalent, so its place in a portfolio is more appropriate as a longer-term piece of the puzzle, than a substitute for emergency cash.

 

If you are thinking an investment in the yellow metal makes sense for the long term, here are a few things you should know before diving in:

 

  • The market for gold is more risky than you might think. It is extremely volatile and often complex. Be aware that there is more nominal value in paper contracts for gold, than physical gold exists to be delivered! And the price of gold does not always move in consistent patterns.

  • Because of the above, particularly if you are worried about protecting yourself from the remote prospect of a meltdown of the financial system; consider owning your gold in the form of the actual metal, instead of the paper alternatives and proxies, like gold mutual funds, exchange-traded funds (ETFs), etc. But keep in mind that you’ll incur storage and convertibility costs when you take delivery of the metal.

  • Gold coins and bullion are considered, for tax purposes, to be a collectible. That means that gains on the sale of gold, as well as shares of gold exchange traded funds and mutual funds, are taxed at higher capital gains rates than most other investment assets.

 

Also — for the newly minted ‘gold bugs’ — consider that you may already own some — and not even know it! Several mutual funds own both gold stocks, and even gold (and silver, and other precious metal) bullion. As is often the case, allowing financial professionals to decide when to buy and sell on your behalf may be wiser than trusting your instincts.

 

 

Taking the longer-term view, consider that from its 1983 peak to the 1999 low, gold lost over half of its value. Stocks, bonds, and even ‘mattress cash’ for 16 years all trounced gold holders, as the hedge against inflation theory failed.

 

The gold enthusiast will rightfully point out that anyone would have preferred the gains in gold over the last 10 years, to the returns on stocks. There’s no denying those with the foresight to buy gold in the past decade will have done well — if they sell at today’s high price and lock in their gains.

 

But, how long will it last? Investors 30 years ago who feared that the high inflation of the period could continue on well into the future sought out gold as a buffer. Many bought in at high prices that wouldn’t be seen again for decades. As those investors learned, changing attitudes about the future can turn a gold rush into a popped gold bubble. So if you do invest, don’t grow too emotionally attached to your gold — or any other investment for that matter.

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