Aug. 24, 2011 -- Many investors are caught up in a gold rush. Signs of it are everywhere. You can't turn on your TV these days without seeing ads selling gold coins or seeking to buy gold jewelry. Headlines in recent months have chronicled the rising price of the precious metal.
Since 2000, gold's price has increased more than 500 percent. This month alone, the price has jumped about 15 percent as the stock marketed has yo-yoed up and down (but mainly down), prompting investors to take refuge in the precious metal. Recent stock market volatility and concern over world economies has driven gold's price to all-time highs, reaching a record of $1,900 per ounce this week.
The underlying reason that gold has been going up in recent years -- even during calmer, richer stock markets -- is simply that many people think the price will keep rising. Regardless of why gold is going up, the rising price must mean that it's always a good investment, right?
Wrong. Though gold can have some short-term uses in a broad portfolio, it's rarely a good candidate for long-term investment. For every steep price run-up like the current one, there has been a deep trough. But unlike many other investments, including stocks, the long-term average of gold's peaks and valleys historically has had little or no real gain.
From 1979 to 2000, gold lost about half its value. And from 1979 until now, it has only doubled in price. Let's say that you bought gold in 1979 (when you could buy health insurance for the entire family for $17 a month), and sat on it for 32 years. Adjusted for inflation, you'd currently have about half of the buying power of the money you started with. About the only way you could have done worse during this period would have been to put your money in your mattress.
The result of gold's price movements is that it acquires little or no real value over time. This is because gold is a commodity, meaning that its value is determined by global trading based on supply and demand. One thing affecting price fluctuations is the large trading volumes of hedge funds. When this trading shifts rapidly, individual investors can be left in the depreciating gold dust.
Even for a precious metal, the price of gold is especially fickle because it has fewer industrial uses than silver or platinum. Gold's value is more emotionally based, and the emotional allure of gold is summed up by one of the biggest drivers of demand: the "love trade" — meaning jewelry for gifts. Another emotion is associated with gold: fear — fear that financial institutions will collapse.
People also buy gold out of greed, believing it will continue to rise indefinitely, as tech stocks did in the 1990s. Remember when that bubble burst? The difference is that, unlike tech stocks, gold has a long history of bubbles.
When stock markets and economies are uncertain, many institutional investors like to park cash in gold for the short term. Among the most common ways to invest in gold is through exchange-traded funds (ETFs). The price of shares (traded like shares of stock) is determined daily by the value of underlying gold stored for investors.
Like all commodities, gold falls into the category of alternative investments — those that can be added to portfolios of traditional investments, such as stocks and bonds, to lessen risk. Alternative investments historically aren't as likely to decrease in value when stocks and/or bonds do, but sometimes they do. When the markets declined in 2008, gold went down with them.
Also, short-term investments in gold can be used to protect against currency declines. If the dollar declines against foreign currencies, an ounce of gold will be worth more dollars. As the buying power of the dollar has declined against the yen and the pound recently, gold has gone up.
But the use of gold in such strategies can be quite tricky, so I don't generally recommend this for individual investors.Even when used sparingly and carefully in broad portfolios, gold has the fundamental problem of being volatile in the long term. It doesn't produce what we primarily invest to obtain: a future income stream. Stocks provide an income stream in the form of dividends and earnings growth, and bonds do so in the form of interest. Gold offers none of these.
Despite these shortcomings, gold can play a strategic role in sophisticated portfolios. But because gold can't deliver long-term returns, it's not the Holy Grail touted in the ads.
Ted Schwartz, a Certified Financial Planner®, is president and chief investment officer of Capstone Investment Financial Group (http://capstoneinvest.net). He advises individual investors and endowments, and serves as the advisor to CIFG Funds. Because Schwartz has a background in psychology and counseling, he brings insights into personal motivation when advising clients on achieving their wealth management goals. Schwartz holds a B.A. from Duke University and an M.A. from Oregon State University. He can be reached at email@example.com