Reasons to Invest in Gold According to Research

Why Is Gold So Valuable?

People buy gold for 3 main reasons. Photo: GeorgePeters/Getty Images

Investors buy gold as for one of three reasons: A hedge, a safe haven or a direct investment.

Gold as a Hedge

Investors use hedges to offset losses in another asset class. Many investors buy gold to hedge against the decline of a currency, usually the U.S. dollar. This also protects against the resultant inflation.

For example, the price of gold more than doubled between 2002-2007, 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 time period. In 2008, despite the financial crisis, some investors continued to hedge against a dollar decline caused by two new factors. One was the Federal Reserve's Quantitative Easing program, launched in December 2008. The other was record-level deficit spending that drove the debt-to-GDP ratio above the critical 90% level. For more details, see Gold Price History.

Gold as a Safe Haven

A safe haven protects investors against a possible catastrophe. That's why many investors bought gold during the 2008 financial crisis. Gold prices continued to skyrocket in response to the eurozone crisis, the impact of Obamacare, the Dodd-Frank Wall Street Reform Act, and the 2011 debt ceiling crisis. Many other wanted to protect their investments against a possible U.S. economic collapse. As a result of this extreme economic uncertainty, gold prices more than doubled again, from $869.75 in 2008 to a record high of $1,895 on September 5, 2011.

Gold as a Direct Investment

Many, many investors saw these tremendous increases in the price of gold and 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. Last but not least, gold is held by many governments and wealthy individuals.

What It Means to You

All investors should have at least some gold in their portfolio, according to a research report from Trinity College. The report found that the best reason to buy gold is as a hedge against a potential stock market crash. That's because gold prices increase dramatically after a crash, but only for about 15 days. After that, gold prices tend to lose relative value against stocks, which often rise again shortly after the crash.

This research showed that gold prices spike when the stock market crashes, as scared investors panicked, sold their stocks and bought gold. However, when the panic was over, the money moved back into stocks, and gold was no longer a better investment.

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. However, gold is an important part of a diversified portfolio which includes other commodities such as oil, mining and investments in other hard assets.

Why Gold?

Why should gold be the commodity that has this unique characteristic? Most likely it's due to its history as the first form of money, and subsequently as the base for the gold standard which set the value for all money.

For this reason, gold confers a familiarity and makes feeling of safety as a source of money that will always have value, no matter what.

This characteristics also explains why tends to be uncorrelated with other assets. This means it doesn't go up 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 so many other investor sentiments. This is another reason to have gold as part of a well-diversified portfolio today's globalized world where most asset classes end up being highly correlated. (Source: D. G. Baur and B. M. Lucey, The Financial Review, Is Gold a Hedge or a Safe Haven? An Analysis of Stocks, Bonds and Gold, 2010 pp. 217–229)  

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