Three Reasons to Invest in Gold According to Research

Why Is Gold So Valuable?

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Investors buy gold as for one of three reasons: a hedge, a safe haven, or a direct investment. Which of these is the best reason? Research says that gold is the best hedge against a stock market crash.

Gold as a Hedge

Hedges are investments that offset losses in another asset class. Many investors buy gold to hedge against the decline of a currency, usually the U.S. dollar. As a currency falls, it creates higher prices in imports and inflation. As a result, gold is also a defense against inflation.

For example, the price of gold more than doubled between 2002 and 2007, from $347.20 to $833.75 an ounce. That's because the dollar's value as measured against the euro fell 40% during that same period.

In 2008, despite the financial crisis, some investors continued to hedge against a dollar decline caused by two new factors. One was the quantitative easing program launched in December 2008. In that program, the Federal Reserve exchanged credit for bank Treasurys. The Fed simply created the credit out of thin air. Investors were concerned this increase in the money supply would create inflation.

The other was record-level deficit spending that drove the debt-to-GDP ratio above the critical 77% level. That expansionary fiscal policy could create inflation. The increase in the nation's debt could also cause the dollar to decline.

Research done by Trinity College found that gold is the best hedge against a potential stock market crash.

For 15 days after a crash, gold prices increased dramatically. Frightened investors panicked, sold their stocks and bought gold. After that, gold prices lost value against rebounding stock prices. Investors moved money back into stocks to take advantage of their lower prices. Those who held onto gold past the 15 days began losing money.

Gold as a Safe Haven

A safe haven protects investors against a possible catastrophe. That's why many investors bought gold during the financial crisis. Gold prices continued to skyrocket in response to the eurozone crisis. Investors were also concerned about the impact of Obamacare and the Dodd-Frank Wall Street Reform Act. The 2011 debt ceiling crisis was another worrying event.

Many others sought protection against a possible U.S. economic collapse. As a result of this extreme economic uncertainty, gold prices more than doubled again. Prices went from $869.75 in 2008 to a record high of $1,895 on September 5, 2011.

Gold as a Direct Investment

Many investors wanted to profit from these tremendous increases in the price of gold. They bought it as a direct investment to take advantage of future price increase.

Others continue to buy gold because they see it as a finite valuable substance with many industrial uses. They believe that supply constraints will eventually force up the value of this metal.

Last but not least, gold is held by many governments and wealthy individuals. For the governments, much of it is legacy gold that's been kept in storage for decades. The U.S. Treasury has stored gold at Fort Knox, Kentucky, since 1937. Selling the gold now would raise anxieties and possibly disrupt markets.

The Federal Reserve does not own gold. It does keep gold owned by the U.S. Treasury in its vault.

What It Means to You

Gold should not be bought alone as an investment. Gold itself is speculative and can have high peaks and low valleys. That makes it too risky for the average individual investor. Over the long run, the value of gold doesn't beat inflation.

But gold is an integral part of a diversified portfolio. It should be included with other commodities such as oil, mining, and investments in other hard assets.

What Makes Gold Special

Why should gold be the commodity that has this unique characteristic? It has a long history as the first form of money. It then became the base for the gold standard which set the value for all money. For this reason, gold confers familiarity. It creates a feeling of safety as a source of money that will always have value, no matter what.

Gold's characteristics also explain why it's uncorrelated with other assets. These include stocks, bonds, and oil. Gold's price doesn't rise when other asset classes do. It doesn't even have an inverse relationship like stocks and bonds do with each other. 

Instead, it is a reflection of many other investor sentiments. That makes another reason to have gold as part of a well-diversified portfolio in today's globalized world where most asset classes end up being highly correlated. (Source: "Is Gold a Hedge or a Safe Haven? An Analysis of Stocks, Bonds and Gold," The Financial Review, 2010 pp. 217–229)  

Disclosure: The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.