How to Invest in Gold: An Investor’s Guide

From the time of ancient civilizations to the modern era, gold has been the world’s currency of choice.

How to buy gold? There are various ways. These include investing in bullion (i.e., gold bars), mutual funds, futures, mining companies, and jewelry. With few exceptions, only bullion, futures, and a handful of specialty funds provide a direct investment opportunity in gold. Other investments derive part of their value from other sources.

Today, investors buy gold mainly as a hedge against political unrest and inflation because of gold’s low value correlation with other asset classes.

In addition, many top investment advisors recommend diversifying a portfolio with commodities, which include gold, to lower overall portfolio risk.

Gold Bullion

This is perhaps the best-known form of direct gold ownership. Many people think of gold bullion as the large gold bars held at Fort Knox in Kentucky.

Actually, gold bullion is any form of pure, or nearly pure, gold that has been certified for its weight and purity. This includes coins, bars, and other forms of gold of any size. A serial number is commonly attached to gold bars, for security purposes.

While heavy gold bars are an impressive sight, their large size (up to 400 troy ounces) makes them illiquid, and therefore costly to buy and sell.

After all, if your entire holding in gold is one large gold bar worth $100,000, and you decide to sell 10%, you can’t exactly saw off the end of the bar and sell it. On the other hand, bullion held in smaller-sized bars and coins provides much more liquidity and is quite common among gold owners.

Problems With Bullion

The main problems with gold bullion are that the storage and insurance costs plus the relatively large markup from the dealer hinder profit potential. Also, buying gold bullion is a direct investment in gold’s value, and each dollar change in the price of gold will proportionally change the value of one’s holdings.

Gold Coins

For decades, large quantities of gold coins have been issued by sovereign governments around the world. Coins are commonly bought by investors from private dealers at a premium of about 1% to 5% above their underlying gold value. But in some cases the premium may be higher.

The advantages of bullion coins are:

• Their prices are available in global financial publications.
• Gold coins are often minted in various smaller sizes (one ounce and less), making them a more convenient way to invest in gold than the larger bars.
• Reputable dealers can be found with minimal searching and are located in many large cities.

Some of the widely circulated gold coins include the South African Krugerrand, the U.S. Eagle, and the Canadian Maple Leaf.

Gold ETFs and Mutual Funds

ETFs

One alternative to a direct purchase of gold bullion is a gold-based exchange-traded fund (ETF). Each share of this specialized security represents a fixed amount of gold, such as one-tenth of an ounce.

You can buy and sell ETFs just like stocks, in any brokerage account or individual retirement account (IRA). This method is, therefore, easier and more cost effective than owning bars or coins directly. This is especially true for small investors, as the minimum investment is only the price of a single share of the ETF.

The annual average expense ratios of these funds are often around 0.61%, much less than the fees and expenses on many other investments, including most mutual funds.

Mutual Funds

Many mutual funds own gold bullion and gold companies as part of their normal portfolios. However, investors should be aware that only a few mutual funds focus solely on gold investing; most own a number of other commodities as well.

The major advantages of the gold-only mutual funds are:

• Low cost and low minimum investment required
• Diversification among different companies
• Ease of ownership in a brokerage account or an IRA
• No individual company research needed

Some funds invest in the indexes of mining companies, and others are tied directly to gold prices. Still others are actively managed. Read their prospectuses for more information.

Traditional mutual funds tend to be actively managed, while ETFs normally adhere to a passive index-tracking strategy and therefore have lower expense ratios.

Gold Futures and Options

Futures

Futures are contracts to buy or sell a given amount of an item—in this case, gold—on a particular date in the future. People often invest in futures because the commissions are very low, and the margin requirements are far below traditional equity investments.

Gold futures contracts are standardized and represent a predetermined amount of gold. As this amount can be large (for example, 100 troy ounces × $1,000/ounce = $100,000), futures are more suitable for experienced investors.

Some contracts settle in dollars, while others settle in gold. So investors must pay attention to the contract specifications to avoid having to take delivery of 100 ounces of gold on the settlement date.

Options

Options on futures are an alternative to buying a futures contract outright. Option owners have the right to buy the futures contract within a certain time frame, at a preset price.

One benefit of an option is that it both leverages your original investment and limits losses from the price paid. A futures contract bought on margin can require more capital than originally invested if losses mount quickly.

The downside of an option is that the investor must pay a premium above the underlying value of gold to own the option. Because of the volatile nature of futures and options, they may be unsuitable for many investors.

Gold Mining Companies

Companies that specialize in mining and refining gold will also profit from a rising gold price. Investing in these types of companies can be an effective way to profit from gold and can carry lower risk than other investment methods.

The largest gold mining companies boast extensive global operations. Therefore, business factors common to many other large companies play into the success of such an investment.

As a result, these companies can still show a profit in times of flat or declining gold prices. One way they do this is by hedging against a fall in gold prices as a normal part of their business. Some do this, and some don’t.

Gold mining companies may provide a safer way to invest in gold than direct ownership of bullion. However, the research into and selection of individual companies requires due diligence on the investor’s part. As this is a time-consuming endeavor, it may not be feasible for many investors.

Gold Jewelry

About 49% of global gold production is used to make jewelry. With the world’s population and wealth growing annually, demand for gold used in jewelry production should increase over time.

On the other hand, gold jewelry buyers are known to be somewhat price-sensitive, buying less if the price rises swiftly.

Buying fine jewelry at retail prices involves a substantial markup—up to 300% or more over the underlying value of the gold. Better jewelry bargains may be found at estate sales and auctions. The advantage of buying jewelry this way is that there is no retail markup. The disadvantage is the time spent searching for valuable pieces.

Nonetheless, jewelry ownership provides an enjoyable way to own gold, even if it is not the most profitable from an investment standpoint. As an art form, gold jewelry is beautiful. As an investment, it is mediocre—unless you are the jeweler.

Gold As a Hedge

Given gold’s low correlation in value with other types of investment assets, investing in the precious metal traditionally has been considered a hedge against economic downturns.

In particular, gold’s correlation with stock market performance has historically remained low, and gold tends to move in the opposite direction to the dollar. This means that periods of dollar weakness could spell strength for gold prices.

The potential benefits of gold as a hedge against declines in other asset classes may come to the forefront of investors’ minds when facing the likelihood of a recession.

Based on historical data, gold prices generally increase when inflation-adjusted bond yields decline. This suggests that there may be some wisdom in allocating a portion of your portfolio to gold as a cushion against rough patches in economic growth.

The Bottom Line

The idea that gold jewelry is an investment is storied but naïve. There is too great of a spread between the price of most jewelry and its gold value for it to be considered a true investment. Instead, the average gold investor should consider gold-oriented mutual funds and ETFs, as these securities generally provide the easiest and safest way to invest in gold.

Larger investors seeking direct exposure to the price of gold can buy gold directly through bullion. Some level of comfort can be found in owning a physical asset instead of simply a piece of paper. The downside is the slight premium to the value of gold paid on the initial purchase, as well as the storage costs.

More aggressive investors can buy gold futures and options. Futures are probably the most efficient way to invest in gold. But let the buyer beware: These investments are derivatives of gold’s price, and they can experience sharp moves up and down, especially when purchased on margin.