GOLD AS AN INVESTMENT OPTION

In the uncertain world of financial markets, gold looks to be an interesting hedging option which an investor can use to protect his portfolio from the wild swings in stock and bond prices. Some arguments are given below to make an investor look at gold with a view to diversifying and allocating a part of his assets to the precious commodity.

The basic argument for a higher price of gold hinges around its property as a store of value and a hedge against inflation. Inflation is a fact of life today and is going to be more so as we get further into 2008. So what options do Governments across the world have to control inflation? Interest rates can only be raised to a certain extent for fear of triggering a downward recessionary spiral in the economy. A case in point is the Japanese economy since 1990 a prime example of deflationary problems. Demand side inflation triggered by rising consumption of almost all primary articles is causing shortages and imbalances in virtually every commodity. Governments are importing inflation by protecting the value of the dollar against their own currencies so as to make their exports competitive.

Historically gold has done exceptionally well in such uncertain times. From December 1969 to December 1980, gold went from a low of $ 35 per ounce to nearly $ 850 per ounce. A gain of 2300 % in 12 years! A similar trend has been visible since the bull market in gold started in December 2000, when it rose from $ 250 per ounce to $ 850 as of now.

Plotting the graph of gold prices against time from December 1969 to December 1978 on one hand and from December 2000 to April 2008 on the other, reveals almost identical trend lines, an appreciation of 300 %. At this very point, in December 1978, nearly 8 years after the start of the bull market, gold prices suddenly took off from $ 200 per ounce reaching an astounding $ 700 per ounce in the next 24 months.

Since the current trend lines are very similar to those in the 1970’ it may be inferred that gold is headed a lot higher in the near future. On extrapolating the present graph to the one in the 1970’ a price of $ 2500 to $ 3000 per ounce looks quite possible in a span of 2 to 3 years. But why should we believe that history will repeat itself? Because all major indicators point to this very scenario playing out. Consider:

Oil rose from $ 2/bbl to $ 50/bbl from 1969 to 1981
Oil has risen from $ 15/bbl to $ 125/bbl from 2000 to 2008

US $ fell 50 % against Yen (1969 to 1981)
US $ has fallen 40 % against Euro (2000 to 2008)

Inflation shot up.

Current account deficits grew many times.

There are more fundamental reasons for the price of gold to increase further.

Gold reserves are limited, only a small number of major gold finds by the mining industry are being discovered.
Gold extraction and refining is an energy intensive process and since energy prices are increasing, so are the costs of gold mining. This is bound to reflect in the price of gold.
With purchasing power increasing in the hands of a resurgent middle class in India and China, demand for jewelry is going up giving a boost to the demand for gold.
Middle Eastern and Asian central banks flush with foreign exchange reserves from a booming economy, are looking to diversify away from US treasury bills into gold.
Gold ETF’ are becoming increasingly popular because they provide an easy and convenient way of investing in gold. This has led to increased demand from ETF’.

The way to super profits from gold may not be a one sided path. For instance when gold went up from $ 35 per ounce in 1969 to $ 850 per ounce in 1980, it suffered a sharp correction from December 1974 to august 1976 when it dipped sharply from $ 195 per ounce to $ 104 per ounce, before eventually regaining its path to new highs. Therefore, any sudden jerks should not deter serious investors, but any sharp downward movements should be looked upon as opportunities to accumulate.

There are 3 ways in which an investor can buy gold:

Physical gold in form of bars and coins. This is the least efficient way because of higher costs and problems in storage.
Gold Exchange Traded Funds (ETF’). The most convenient and transparent way because ETF’ are listed on stock exchanges providing ease of entry and exit.
Stocks of gold mining companies and mutual funds investing in these. A high risk high return strategy, because if price of gold goes up these stocks go up far more in percentage terms and vice versa.

Even though gold prices are highly volatile, the real value of gold lies not as a speculative investment but in its ability to provide a safe and steady means of protecting wealth and to improve risk adjusted returns for an investor.