Last Updated on August 14, 2020
If you’ve never thought about gold as an investment, don’t feel bad. According to a 2019 survey, only 12% of the US population owns gold as a part of their investment portfolio. So why does investing in gold become a hot topic every now and then? Because the price of gold often goes up when the stock market goes down. But before you make any portfolio adjustments, there are some important things to consider that will help you decide whether or not gold is a good investment for you.
Investing for growth vs. investing to retain value
Bear with us while we get nerdy for a moment. In order to understand how gold differs from other, more traditional investments, you need to understand the difference between two major types of assets: productive and unproductive assets.
Productive assets are those that increase in value over time. Many investments in this category also generate additional assets as they grow. For instance, dividend-paying stocks not only can increase their value over time but also provide you an additional source of income through dividend payments. Another example of a productive asset is the ownership of rental properties. Not only do you increase your net worth through the appreciation of the property, but you also receive cash flow through rental income.
Unproductive assets include things like gold and other precious metals. The price of gold changes over time depending on supply and demand. No surprise there. However, despite the ups and downs in price, the value of gold generally keeps pace with inflation over the long run. That is quite different from other assets that simply ‘hold’ value, like cash.
Over time, cash will lose value to inflation if it’s left sitting to its own devices. The investment opportunity for unproductive assets like gold occurs when you expect that someone will be willing to pay more for that gold in the future than what you originally purchased it for.
If gold is an unproductive asset, why do people invest in it?
It keeps up with inflation
Historically gold has done very well as a hedge against inflation. So while it may not be considered a productive asset, it provides an opportunity for investors to store value relatively safely. This is in contrast to other forms of currency, for example, the US Dollar, which tends to lose purchasing power over time due to inflation.
Diversifying your portfolio
As previously discussed, gold prices tend to go up when the stock market goes down. Using that logic, some people choose to invest in gold to help diversify their portfolio. Diversification is an effective way to help reduce the overall risk exposure within a portfolio. Investing in different industries, sectors, and countries can help ensure that if one area of the market suffers a decline, your entire portfolio won’t necessarily decline to that degree. Essentially, diversification can help reduce the impact market volatility has on your portfolio.
However, just as diversification can help lessen the blow when certain stocks take a hit, it can also limit growth. For a very simplified example, let’s say you have 2 stocks in your portfolio. They’re from different industries and therefore increase your portfolio’s diversification. When Stock A’s value plummets, Stock B’s value could increase, reducing your overall losses. The reverse is also true though. When Stock A’s value starts to skyrocket, Stock B’s value might begin declining, limiting your portfolio’s overall growth.
Be careful not to over-diversify…
Diversification is a two-way street. So, it’s important to be smart about how much you diversify your portfolio, and how you go about it. There is such a thing as over-diversification. Over-diversification essentially means that your portfolio is so diversified that it ends up cannibalizing any of the gains you would have received. Every gain is negated by a loss somewhere else within your portfolio. A perfectly optimized portfolio is diversified enough to reduce risk while, at the same time, being aggressive enough to harness gains. If you are looking for specific guidance on how to do this, I would recommend contacting a financial advisor.
Is investing in gold a good way to diversify?
Determining how much to diversify your portfolio is important. Determining what to diversify your portfolio with is just as important. Check out these two graphs below. Each graph compares the investment return for the S&P 500, Dow Jones, Gold, and Silver. Those who tout gold as being a good investment would highlight the specific moments in time where gold outperforms the stock market.
Looking at how gold performs on a 5-month timeline, however, is very misleading. This next graph shows how it performs over a span of 100 years.
In this macro-scale analysis, it becomes obvious that gold underperforms compared to the S&P 500 and the Dow Jones.
The bottom line
Investing in gold is not necessarily a bad thing. But for most investors, it is better not to think of gold as an investment at all. Gold does two things well, it stores value, and it hedges your portfolio against inflation. Just remember that gold is an unproductive asset. Its value (like any form of currency) is dependent on changes in supply and demand. Gold is not producing a new good or service. I’ll leave you with this- when asked about gold as an investment, Warren Buffett said, “It doesn’t do anything but sit there and look at you.”