The Best Strategy for Gold Investors

The Stuff That Dreams are Made Of

The pursuit of gold has led to murder and mayhem, wars, and an unrelenting fascination for much of history. Gold is so important that it has become synonymous with the word "wealth." But having gold nuggets, coins, or CFD's does not mean your portfolio value is rising, or that it's safe. Let's explore gold as part of your investment portfolio.

Most of the gold supplied to the market each year goes into manufactured products, with the remainder going to private investors and monetary reserves. Gold has a long history of use as currency or as a reserve backing for other forms of money. However, the gold standard is not currently used by any government, having been replaced completely by fiat currency.

Diversification of a portfolio means using varying asset classes to build a portfolio. Stocks and bonds are the primary asset classes, with commodities, including gold, coming in as a relatively small asset allocation. The going wisdom is that commodities, including gold, should comprise no more than 5% of your portfolio (10% if you're aggressive and commodities are in a rising market trend).

Portfolio planning also takes into consideration intent. Is the intent to increase wealth or to have gold, which can at any time be traded for food or shelter? Both goals can be accomplished with knowledge of the markets. Gold held for an emergency is different than buying a CFD or stock in a gold mining company. Holding gold against an emergency does not necessarily increase wealth. Gold can be part of one's wealth, but it can decrease in value too.

Let's compare buying gold Krugerrands to buying another physical asset, such as a home. Whether the price of the home goes up or down, you still have a home to live in and it is part of your estate. Whether the price of gold Krugerrands goes up or down, you still hold them and they are part of your estate. Now let's look at buying shares of an exchange-traded fund (ETF) like the SPDR Gold Shares GLD (NYSE: GLD). If the price goes down from where you buy it, you have lost money and the paper may even become worthless if market selling action greatly overshadows buying action. That said, ETFs are backed by tangible gold reserves, but the ETF share values are sensitive to technical (supply vs. demand) dislocations.

Trading Gold with CFD's

While there are multiple ways to buy or sell gold, such as gold ETF's, gold futures, or physical gold, the easiest and most accessible are gold CFD's, which are routinely offered on most electronic trading platforms. A gold CFD represents an agreement between you and your broker (the trading platform) to trade the price of spot gold. No exchange of physical gold takes place when buying gold through a CFD, Rather, after a spot gold position is opened through the purchase of a CFD, once it is closed (sold), your broker settles the trade in US dollars based on the price change between your entry price and your closing price.

Aside from market risk, (e.g. the price of spot gold moves against your position), CFD's carry credit risk. This is the risk that your broker is unable to settle the CFD when the time comes, which likely means your broker has gone bankrupt, which is rare, but not impossible.

A gold futures contract, on the other hand is a legally binding agreement for the delivery of gold in the future at an agreed-upon price. The contracts are standardized by a futures exchange as to the quantity, quality, time, and place of delivery. Only the price is variable. The contract refers to the commodity "gold." Stocks of gold miners or related companies offer shares, but this does not represent any form of gold ownership.

Gold bullion is any type of gold product that is sold for the gold content. The price of gold bullion, in whatever form, follows the daily spot price of gold. The gold bullion market is international. The demand is global. Gold is being traded somewhere in the world at virtually every hour of the day.

The Golden Commodity

The phrase "flight to quality" often refers to gold, among other assets, such as US Treasuries, which is often called the currency of last resort. The premise is that if there is an economic collapse and paper money becomes obsolete, gold will retain value. Currency is any form of money of any country, and money is anything that can be exchanged or bartered for something else, making gold the ultimate form of money during an economic recession.

If the desire is to have a commodity as an alternative medium of exchange, buy gold bullion. Foreign currencies do not replace gold because no country is on the gold standard. A purchase may require more or less gold, depending on demand, but gold is usually acceptable.

Gold stocks are not redeemed for gold. Gold futures contracts are seldom redeemed for gold. Buying into a gold fund or index does not mean you have possession of the commodity gold. Buying foreign currencies is not a substitute for the commodity gold.

Ownership of gold is accomplished only by purchasing gold bullion. Gold bullion is any type of gold product that is sold for the gold content. It can be gold coins, gold bars, or gold jewelry.

Trading Gold and Inflation

Many market followers think of gold as a hedge against inflation, meaning that if inflation is high and rising, the price of gold will similarly rise in value. However, the relationship is tentative at best as seen below with CPI rising rapidly in 2021-22, and gold declining during that period.

Gold and Currencies

The foreign exchange market (forex or FX) refers to the market for currencies. The foreign exchange market does not imply any representation of gold. It is plainly one country's currency against another. That said, gold is frequently traded alongside the broader FX market and the US dollar in particular.

Gold's relationship with the US dollar, both considered safe haven assets, is complicated and varies widely depending on market conditions. For example, let's say markets are in turmoil due to an unexpected, negative news or data event. Stocks may be falling, and investors may seek safe havens such as gold or US Treasuries, by buying the USD to purchase short-term safe haven Treasuries. In this scenario, both gold and the USD may benefit from the short-term market dislocation.

On the other hand, if markets are in extreme turmoil, and stocks and commodities are both collapsing, gold may get sucked into the overall commodity market collapse and no longer offer safe haven status. On such occasions, the USD has proven to be the most effective safe haven asset and is considered the currency of last resort, followed by the Swiss franc (CHF) and the Japanese yen (JPY).

In the charts below, we can see that both gold and the US dollar (as shown by the US dollar index) strengthened on the back of US interest rate hikes by the Fed, and a slide in the US stock market, leading investors to seek refuge in the two safe haven assets. But the US dollar has recently moved lower on fears of a US recession in 2023 and the anticipated end of aggressive rate hikes by the Fed. Meanwhile, gold has remained elevated due to recession fears and general stock market weakness.

The Bottom Line

Gold, with all its mystique, is just another commodity or form of currency; there's nothing magical about it. As a safe haven asset, owning gold works relatively well in times of mild negative market volatility. But during periods of extreme turmoil, where investors are selling everything from stocks to commodities, gold can get caught up in the volatility and be sold alongside other commodities, negating it's safe haven status.

Gold is most easily traded as a CFD on most broker-based electronic trading platforms, but can also be traded using gold futures and Gold ETF's. In terms of portfolio allocation, gold should be a minor means of diversification; generally speaking, no more than 5% of a total portfolio.