Want to use gold investments as a hedge? Here’s a breakdown of why it’s a smart idea to diversify your portfolio with the yellow metal.
For investors that tend to fill their portfolios with specific assets, it’s pertinent that they include some diversification to act as a hedge during times of instability with their primary investments.
For many market participants, gold has been a reliable portfolio diversifier due to the fact that it has the ability to act as a hedge against portfolio volatility.
Here we examine how gold investments allow risk diversification and why they are a good hedge, as well as how to use gold investments as a portfolio hedge.
Why use gold investments as a hedge?
In order to understand why investing in gold is a good hedge, let’s break down what a hedge is. A hedge is an investment position that’s main purpose is to offset potential losses or gains that may happen to a particular asset within an individual’s portfolio.
With that in mind, the yellow metal is looked at as a hedge investment in many different situations. The first, and probably the most popular use of gold as a source of protection, is when investors want to use it to hedge against the decline of a currency, typically the US dollar. When the dollar slips, the yellow metal not only becomes less expensive to hold, but also rises in value.
“Gold’s relationship with the dollar is determined by US-based gold supply and demand, as well as by the status of the dollar as the reserve currency globally,” said the World Gold Council in a report.
“Historically, a weak dollar tends to provide a stronger boost to gold’s performance than the drag created by a strong dollar,” they added.
By holding the precious metal as a diversification tool when the economy negatively affects currencies, investors can incur gains from the metal’s increased value. Additionally, gold can also act as a defence against inflation.
This is the second reason why gold makes a good hedge — its resilience in the face of inflation. When the cost of living begins to rise (inflation), the stock market tends to plunge. If you are an investor with assets that are directly negatively affected by a volatile market, you will need something in your portfolio to balance that out — enter gold.
Over the past 50 years, investors have been witnesses to the gold price making huge gains when the stock market is crumbling.
As Investopedia points out, “This is because, when fiat currency loses its purchasing power to inflation, gold tends to be priced in those currency units and thus tends to arise along with everything else.”
On the flip side of inflation, the yellow metal has also been used as a hedge against deflation. Although this situation has not occurred since the Great Depression of the 1930s (and to a much smaller degree after the 2008 financial crisis), deflation occurs when prices drop, the economy is in a downturn and excessive debt looms.
As a result, market participants make the decision to hoard cash, and the safest place to hold cash is in gold. Again, while this situation is not commonplace, many investors keep the yellow metal in their portfolio on the off chance another massive period of deflation takes place.
Finally, gold investing is used as a hedge when it exists within an individual’s portfolio as a source of diversification. Portfolio diversification takes place when market participants hold investments that are not related to one another. Since the precious metal has a history of having a negative correlation to stocks, bonds and other financial instruments, it becomes important that investors get diversified by owning a portfolio that combines gold with stocks and bonds in order to reduce both volatility and risk.
While it is true that the yellow metal goes through times of volatility, its spot price has always maintained its value over the long term.
How to use gold investments as a hedge
Once you have the yellow metal in your portfolio, it is important to understand how to then use it as a hedge. There are various avenues that one can go down when implementing the precious metal as a hedge in your portfolio. Below, the Investing News Network (INN) explores three of the most popular options.
Gold exchange-traded funds (ETFs):
One of the common ways in which investors introduce gold as a hedge into their portfolio is through investing in a gold ETF. A gold ETF is similar to trading a stock on an exchange, and there are several gold ETF options to choose from. For instance, some ETFs focus solely on physical gold bullion, while others focus on gold futures contracts. Still others focus on the gold mining market itself or follow live prices for the metal.
It is important to keep in mind that you will not own any physical gold when investing in any ETF platforms — even a gold ETF that tracks physical gold cannot be redeemed for tangible yellow metal.
For some gold ETF inspiration, check out INN’s list of 5 popular ETFs.
Physical gold investors are generally looking for items that are 0.999 fine. Several products fit this description, and one of the most preferred is gold bullion coins, such as the South African Krugerrand or the American Gold Eagle.
Another option is gold rounds, which are similar to coins, but are not legal tender. Gold bars are another popular option. They also come in a variety of sizes, so this category of products can accommodate a range of investors.
For investors looking to make large investments, these may be best made in bars since larger sizes are available. Further, it is often easier to manage large products than it is to manage an array of smaller gold items.
Keep in mind when you may want to sell your gold. Large products will require liquidating a larger portion of one’s gold portfolio, and such products may be more difficult to sell in some instances. Individuals making ongoing or significant investments may therefore want to consider purchasing gold in various weights.
If you are looking to purchase physical gold as a hedge in your portfolio, it can be done through government mints, private mints, precious metals dealers and even jewelry stores.
A futures contract is an agreement to buy or sell gold on a date in the future for a price that is determined when the contract is initiated. The futures market is often referred to as an arena for paper trading. Generally, the bulk of the activity is just that, as metal is not actually exchanged and settlements are made in cash.
However, the futures market can also be an arena for purchasing physical gold. Obtaining gold through the futures market requires a large investment and involves a list of additional costs. The process can be complicated, cumbersome and lengthy, which is why this option is considered best for highly experienced market participants. You can learn more about gold futures here.
No matter the form of gold investment, the metal continues to prove itself as a diversifier that offers an offset to losses tied to other assets within a portfolio.
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Securities Disclosure: I, Nicole Rashotte, hold no direct investment interest in any company mentioned in this article.