Investing in gold

Imagine yourself swirling water in a pan next to a stream, desperately hoping to see a yellow glint of gold and dreaming of striking it rich. Australia has come a long way since the early 1850s, but gold still holds a prominent place in our global economy today. 

Here's a comprehensive introduction to gold, including why it's valuable and how we obtain it, how to invest in it, the risks and benefits of each approach, and advice on where beginners should start.

Why is gold valuable?

In ancient times, gold's malleability and lustre led to its use in jewellery and early coins. It was also hard to dig gold out of the ground. The more difficult something is to obtain, the higher it is valued. 

Over time, humans began using the precious metal to facilitate trade and accumulate and store wealth. Early paper currencies were generally backed by gold, with every printed note corresponding to an amount of gold held in a vault where it could technically be exchanged (this rarely happened). 

This approach to paper money lasted well into the 20th century. Today, modern currencies are largely fiat currencies, so the link between gold and paper money has long been broken. However, people still love the yellow metal.

Where does demand for the yellow metal come from?

The largest demand industry, by far, is jewellery, which accounts for about 50% of gold demand. Another 40% comes from direct physical investment in gold, including that used to create coins, bullion, medals, and gold bars. (Bullion is a gold bar or coin stamped with the amount of gold it contains and the gold's purity. It is different from numismatic coins, which are collectibles that trade based on demand for the specific type of coin rather than the coin's gold content.) 

Investors in physical gold include individuals, central banks and, more recently, exchange-traded funds (ETFs) that purchase gold on behalf of others.

Gold is often viewed as a safe-haven investment. If paper money suddenly became worthless, the world would have to fall back on something of value to facilitate trade. This is one of the reasons investors tend to push up the price of gold when financial markets are volatile.

Since gold is a good conductor of electricity, the remaining 10% of demand for gold comes from industry for uses, including dentistry, heat shields, and tech gadgets. 

How is the gold price determined?

Gold is a commodity that trades based on supply and demand. The interplay between supply and demand ultimately determines the spot price of gold at any given time.

Demand for jewellery is relatively constant, though economic downturns can lead to a temporary reduction in demand from this industry. However, the demand from investors, including central banks, tends to track the economy and investor sentiment inversely. 

When investors are worried about the economy, they often buy gold and, based on the increase in demand, push its price higher. You can keep track of gold's spot price ups and downs at the website of the World Gold Council, an industry trade group backed by some of the largest gold miners in the world.¹ 

How much of this commodity is out there?

Gold is quite plentiful, but it is difficult to extract. For example, seawater contains gold, but in such small quantities, it would cost more to extract than the gold would be worth. So, there is a big difference between the availability of gold and how much exists.

In early 2021, the World Gold Council estimated about 197,576 metric tonnes of gold above ground are being used today. And roughly 54,000 metric tonnes of gold could be economically extracted from the earth using current technology. 

Advances in extraction methods or a materially higher gold price could shift that number. Gold has been discovered near undersea thermal vents in quantities that suggest it might be worth extracting if prices rose high enough. 

How do we obtain gold?

Although panning for gold was a common practice during the Australian gold rush, nowadays, it is mined from the ground. While gold can be discovered by itself, it's more commonly found along with other metals, including silver and copper. Thus, a miner may produce gold as a by-product of its other mining efforts.

Miners begin by finding a place where they believe there is gold in large enough quantities that it can be economically obtained. Then, local governments and agencies have to grant the company permission to build and operate a mine.

Developing a mine is a dangerous, expensive, and time-consuming process. There is little to no economic return until the mine is finally operational, which often takes a decade or more from start to finish. 

How well does it hold value in a downturn?

The answer depends partly on how you invest in gold, but a quick look at the gold price relative to share prices during the bear market of the 2007-2009 recession provides a telling example.

Between 30 November 2007 and 1 June 2009, the S&P/ASX 200 Index (ASX: XJO) fell almost 50%. The price of gold, on the other hand, rose 25%. This is a recent example of a material and prolonged share market downturn. It's also a particularly dramatic one because, at the time, there were very rea­l concerns about the viability of the global financial system.

When capital markets are in turmoil, gold shares often perform relatively well as investors seek out safe-haven investments.

Ways to invest in gold

Here are all the ways you can invest in gold, from owning the actual metal to investing in companies that finance gold miners.

Jewellery

The mark-ups in the jewellery industry make this a bad option for investing in gold. Once you've bought it, its resale value will likely fall materially. This also assumes you're talking about gold jewellery of at least 10 karats (pure gold is 24 karats.) Costly jewellery may hold its value, but more so because it becomes a collector's item than because of its gold content.

Bullion, bars, and coins

These are the best options for owning physical gold. However, there are mark-ups to consider. The money it takes to turn raw gold into a coin is often passed on to the end customer. Also, most coin dealers will add a mark-up to their prices to compensate them for acting as middlemen.

Perhaps the best option for most investors looking to own physical gold is to buy gold bullion directly from the Royal Australian Mint, so you know you are purchasing from a reputable dealer.

Then you have to store the gold you've purchased. That could mean renting a safe deposit box from the local bank, where you could pay an ongoing storage cost. Meanwhile, selling can be difficult since you have to bring your gold to a dealer, who may offer you a price below the current spot price.

Gold certificates

Another way to get direct exposure to gold without physically owning it, gold certificates are notes issued by a company that owns gold. These notes are usually for unallocated gold, meaning there's no specific gold associated with the certificate, but the company says it has enough to back all outstanding certificates. You can buy allocated gold certificates, but the costs are higher. 

The big problem here is that the certificates are only as good as the company backing them, like banks before the Federal Government's Financial Claims Scheme was created. 

This is why one of the most desirable options for gold certificates is the Perth Mint, which the government of Western Australia backs. That said, if you buy a paper representation of gold, you might want to consider ETFs instead. 

ETFs

If you don't particularly care about holding the gold you own but want direct exposure to the metal, then a gold ETF like ETFs Metal Securities Australia Ltd is probably the way to go. This fund directly purchases gold on behalf of its shareholders. You'll likely have to pay a commission to trade the ETF, and there will be a management fee, but you'll benefit from a liquid asset that invests directly in gold coins, bullion, and bars.

Futures contracts

Another way to own gold indirectly, futures contracts are a highly leveraged and risky choice that is inappropriate for beginners. Even experienced investors should think twice here. Essentially, a futures contract is an agreement between a buyer and a seller to exchange a specified amount of gold at a specified future date and price. 

As the gold price moves up and down, the value of the contract fluctuates, with the accounts of the seller and buyer adjusted accordingly. Futures contracts are generally traded on exchanges like the ASX, so you'd need to talk to your broker to see if it supports them. 

The biggest problem: Usually, futures contracts are bought with only a small fraction of the total contract cost. For example, an investor might only have to put down 20% of the full cost of the gold controlled by the contract. This creates leverage, which increases an investor's potential gains — and losses. And since contracts have specific end dates, you can't simply hold on to a losing position and hope it rebounds. 

Futures contracts are a complex and time-consuming investment that can materially amplify gains and losses. Although they are an option, they are high-risk and not recommended for beginners.

Gold mining shares

One major issue with direct investment in gold is that there's no growth potential. An ounce of gold today will be the same ounce of gold 100 years from now. That's one of the key reasons famed investor Warren Buffett doesn't like gold — it is, essentially, an unproductive asset.

This is why some investors turn to gold mining shares. The share prices of gold mining companies tend to follow the gold commodity price. However, miners also run businesses that can expand over time so that investors can benefit from their increased production. This can provide the upside that owning physical gold never will.

However, running a business comes with accompanying risks. Mines don't always produce as much gold as expected, workers sometimes go on strike, and disasters like a mine collapse or deadly gas leak can halt production and even cost lives. All in all, gold miners can perform better or worse than the gold price depending on what's going on with the miner.

In addition, most gold miners produce more than just gold. That's a function of the way gold is found and diversification decisions made by the mining company's management. 

If you're looking for a diversified investment in precious and semi-precious metals, then a miner that produces more than just gold could be a net positive. However, if you want pure gold exposure, every ounce of a different metal that a miner pulls from the ground simply dilutes your gold exposure.

Potential investors should pay close attention to a company's mining costs, existing mine portfolio, and expansion opportunities at both existing and new mines when deciding which gold mining shares to buy.

Mining-focused ETFs

If you want a single investment that provides diversified exposure to gold miners, low-cost index-based ETFs such as VanEck Gold Miners ETF AUD or the BetaShares Global Gold Miners ETF — Currency Hedged are good options. Their expense ratios are 0.53% and 0.57%, respectively.

As you research gold ETFs, look closely at the index being tracked. Pay particular attention to how it is constructed, the weighting approach, and when and how it gets rebalanced. These are important pieces of information that are easy to overlook when you assume a simple ETF name will translate into a simple investment approach.

There's no perfect way to own gold because each option comes with trade-offs. However, what to invest in is just one piece of the puzzle. There are other factors that you need to consider.

How much should you invest in gold?

The price can be volatile, so you shouldn't invest large amounts of money into gold. We think keeping it to less than 10% of your overall share portfolio is best. 

The real benefit for new and experienced investors comes from the diversification that gold can offer. Once you've built your gold position, make sure to periodically balance your portfolio so that your relative exposure to it remains the same.

When should you buy?

It's best to buy small amounts over time. When the gold price is high, the prices of gold-related shares also rise. That can mean lacklustre returns in the near term, but it doesn't diminish the long-term benefit of holding gold to diversify your portfolio. You can dollar-cost average into the position by purchasing a little at a time.

As with any investment, there's no one-size-fits-all answer for how you should invest in gold. But armed with the knowledge of how the gold industry works, what each type of investment entails, and what to consider when weighing your options, you can make the decision that's right for you.

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