The Best Strategy for Gold Investors

The pursuit of gold has led to murder and mayhem, wars and 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 futures contracts does not mean your portfolio value is rising, or that it's safe. Let's explore gold futures, as well as usage in an 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. (To learn more see, The Gold Standard Revisited.)

Investing in the financial markets demands the ability to change perspectives over time. If gold bars or Krugerrands (a one-ounce South African gold coin) are purchased, then the physical possession of that gold remains the same regardless of the market price. Investment is a choice to risk capital with the hope of gain. Yet ownership is for the sake of ownership, regardless of any gain in price.

Diversification of a portfolio means varying the asset classes. Stocks are one asset class. Gold is another. Owning a company's stock means owning an equity stake in a company. The value goes up or down, changes with the market and the paper certificates can be worth nothing. The value of gold goes up and down and changes with the market but is never worth nothing. Therein lays the major difference. You may not profit from owning gold, but at least you will own a desirable tangible asset, whatever the monetary value.

Figure 1: Gold futures prices go up, down and sideways. The commodity is the same, the price is not.

Source: TradeStation

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 futures contract 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 (EFT) like the SPDR Gold Shares GLD (NYSE: GLD) (Figure 2). If the price goes down from where you buy it, you have lost money and the paper may even become worthless.

Figure 2: This is the gold trust GLD. It follows the movement of gold, but it is not a hard asset.

Source: TradeStation

There are two ways to invest in the gold market, either buying the physical commodity gold or buying a futures contract. Buying the physical commodity gold is to have ownership. Thus, although the price will fluctuate, ownership is final. Buying a futures contract or stock is speculation, where you do not own any gold but can make a profit. (To learn more, read The Gold Showdown: ETFs Vs. Futures and Trading Gold and Silver Futures Contracts.)

A gold futures contract is a legally binding agreement for delivery of gold in the future at an agreed upon price. The contracts are standardized by a futures exchange as to quantity, quality, time and place of delivery. Only the price is variable. The contract refers to the commodity "gold." Gold stocks are not a commodity in this sense. 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 phrase "flight to quality" usually refers to gold, 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. (For further reading on how money is exchanged, read From Barter to Banknotes.)

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. (For more, see What Is Money?)

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.

Figure 3: Examples of gold bullion

Source: Northwest Territorial Mint

Money and gold may seem the same, and they can all be equally acceptable currency, but they are different. Money is anything accepted as payment. Currency is often country-specific and is represented by paper notes issued by the government. It is money but it is not gold. Gold (as well as silver) is money and a medium of exchange. Gold can be currency, but it is also more than that, as it is a tangible asset and the only investment not monetized by debt.

Figure 4, below, shows the inverse relationship between gold and the U.S. dollar.

Figure 4: Gold and the U.S. dollar are inversely correlated. When the dollar rises, gold prices fall.

Source: TradeStation

The next chart (Figure 5) shows an inverse relationship between the U.S. dollar and the Swiss franc. The Swiss franc generally moves opposite to the U.S. dollar. The Swiss franc is positively correlated with gold. Correlations are a good management tool for making allocations in a portfolio.

Figure 5: The U.S. dollar and the Swiss franc are inversely correlated

Source: TradeStation

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. Fiat money is redeemable for nothing, while gold always retains monetary status. (To learn more, see Common Questions About Currency Trading.)

The next chart (Figure 6) is a cross rate (or a currency pair that does not include the U.S. dollar) compared to gold. No country's paper notes are convertible into pre-set, fixed quantities of gold.

Figure 6: A cross-rate currency pair compared to gold, showing a positive correlation

Source: TradeStation

The euro/Japanese yen pair is positively correlated to gold (Figure 5), the price is up or down at the same time. The purchase of gold and this currency pair is not diversified as the loss or gain is twice as much. (For more, see Tales from the Trenches: Perfectly Negative Profitability.)

Figure 7: A gold chart and the S&P 500

Source: TradeStation

In Figure 7, the SPY was already moving up years before gold started moving up. From 2004 to 2008, the SPY is up 50%. Gold did not start rising out of range until late 2007. The stock market fell back to the 2004 lows and gold prices are also lower. Commodities lagged the equities market for this time cycle. Clearly, portfolio management is more effective when cycles of the economy are taken into account.

There is a saying that "commodities will protect portfolios from market risk." However, there is the market risk, systemic risk and price risk in every asset class. The only protection for a portfolio is the wise management of assets. In other words, although gold has many benefits for investors, holding gold does not ensure the appreciation of assets. The Midas touch is really just good money management.