I believe most investors and savers should hold up to 10% of their investible assets and personal savings in physical gold and for some high-net-worth investors a greater percentage allocation to gold may be appropriate.
Physical gold serves at least four important investment objectives:
- First, it provides a form of financial insurance should unforeseen economic or political events diminish the value or liquidity of your ordinary equity, fixed income, or real estate assets. This alone is sufficient reason to allocate up to 10% of one's investments and savings to physical gold. And, just like life insurance, your home-owners insurance, your health insurance and your auto insurance, you're happiest never collecting.
- Second, gold is the preeminent inflation hedge, offering protection against excessive monetary creation, future inflation at home and U.S. dollar devaluation in world currency markets.
- Third, it is a unique portfolio diversifier. Even though the price of gold may be, at times, quite volatile, because its price movements tend to be uncorrelated with the ups and downs in other asset prices, it reduces the volatility and price risk in one's overall investment portfolio. In other words, a portfolio including gold is over time less volatile than the same portfolio excluding gold.
- Fourth, gold's supply/demand fundamentals – especially expected growth in both jewelry and investment demand from China and India as well as increasing central-bank reserve accumulation – suggest its price will move sharply higher in the next three-to-five years – and is likely to continue outperforming most other investments, much as it has over the past decade.
Many investors confuse gold with gold-mining equities, gold exchange-traded funds (ETFs) and other "paper" gold investment products. But when I recommend holding up to 10% of one's overall investments and savings in gold, I'm talking about physical gold – bullion bars and bullion coins – that you can actually hold and store on your own or with a safe-deposit facility of your own choosing.
And, I'm talking about long-term holdings of physical gold – holding that you might sell as a last resort. If you wish to actively trade gold, speculate in short-term price movements, or bet on gold-mining shares, go right ahead – but understand that these positions should be in addition to – not instead of – your "core" percentage.
One of the main reasons to own physical gold is risk reduction – to reduce or avoid the risks that threaten ordinary investments and savings including equities, bonds, mutual funds, gold ETFs and foreign currencies.
Gold-mining equities, unlike physical gold, do not lower risk but actually subject the investor to a myriad of risks not associated with ownership of the physical metal. These include:
- Management risk – the risk that company executives and directors will make poor decisions and mismanage the companies business. This includes diversification away from gold to other mineral mining or
- Stock-market risk – the risk that a swift decline in equity prices (such as the "Flash Crash" of May 2010) will drag gold-mining shares lower along with everything else.
- Exchange risk – the risk that stock exchanges close or trading is suspended due to terrorism, natural catastrophe, computer hacking, or government mandate.
- Political or country risk – the risk of nationalization of mining assets (as occurred in recent years in Venezuela and is now threatened in South Africa, Mongolia and some South American countries) or the imposition of hostile government regulations, including environmental regulations, that increase costs and slow development of new and existing mines.
- Tax risk – the risk that mines may be subject to excessive or punitive taxation as illustrated by the recent Obama budget proposals calling for a five-percent royalty on revenues from all domestic US mining activities.
- Cost inflation – although gold is an inflation hedge, mining companies are subject to rising costs for energy, labor, steel, chemicals and other inputs.
Historically, some investors have preferred gold-mining equities to the real thing, simply because they offered leveraged exposure to the gold price. When gold prices went up, gold-share prices generally went up more.