Everything you need to know about investing in gold

"The whole fearmongering that the world is going to end is just not working."

By Tom Anderson | June 19, 2013

Unfortunately, turmoil in the precious-metals market doesn't necessarily mean cheaper bling.

Everywhere you look, people are talking about gold, and it isn't even Oscar season. So why have precious metals been taking center stage?

Well, when investors are scared, they have historically bought gold, silver and other precious metals as a security blanket.

Beyond their uses in jewelry and industry, precious metals are seen as a hedge against inflation. Why? Because investors assume such metals will hold or increase in value as major currencies decline in value due to financial uncertainty.

Famed investor Warren Buffett describes the dynamics of this phenomenon best when he talks about gold: "Gold is a way of going long on fear, and it has been a pretty good way of going long on fear from time to time. But you really have to hope people become more afraid in a year or two years than they are now. And if they become more afraid, you make money; if they become less afraid, you lose money. But the gold itself doesn't produce anything."

In other words, precious metals tend to soar in price when investors have great anxiety about the future. But when that angst goes way, prices fall back to earth.

Well, judging from the prices of precious metals, investors don't expect to be fearful a year or two from now. Gold prices have fallen more than 17 percent this year. Exchange operator CME Group had to halt the trading of silver four times on May 19 after prices plunged more than 9 percent that day.

How gold reflects on the economy

The bad news for precious-metals prices can actually be a good sign. It means investors feel better about the economy. And with good reason: The housing market has begun to bounce back from the Great Recession, the Standard & Poor's 500-stock index — a broad measure of market performance — has returned 15 percent so far this year, and consumer confidence is at its highest level since July 2007.

Precious metals are known as commodities. That means they should be the same no matter who produces them. Gold, silver and platinum are commodities as well as corn, sugar and wheat. So is oil and natural gas.

Commodities trade on exchanges around the world. Commodity prices are extremely volatile and difficult to predict. Gold is a prime example as a commodity with long-term price movements that can shift very rapidly.

Just look at 1980: The prices for an ounce of gold rose to a then all-time high of $850 an ounce in January of that year, partly on fears that then Federal Reserve Chairman Paul Volcker would not be able to tame rampant inflation. As Volcker demonstrated his ability to raise the federal funds rate to control inflation, investors realized the end was not nigh and they rushed for the exits. The price of gold fell to $590 an ounce by that December.

Then, gold prices continued to decline, hitting a 20-year low of $258 an ounce in 1999. But another gold rush had started as the 2000 recession hit. From 2000 to 2012, gold prices increased sixfold. Now this year gold prices have begun to plunge again. It's a roller coaster few investors can stomach.

"Gold has faced disappointment after disappointment," John Stephenson, a fund manager for First Asset Investment Management Inc., in Toronto, told Bloomberg News. "It's had a 12-year run, but the whole fearmongering that the world is going to end is just not working. So, I think that any last vestige of an investment thesis for gold has been stripped."

Silver prices generally follow a similar pattern to gold, but are not always in lockstep. That's because the supply and demand of the two metals is different, and silver has more industrial applications than gold. Same goes for platinum, which has fallen less sharply in price this year than both gold and silver.

What does this mean for the jewelry market?

Unfortunately, the turmoil in the precious-metals market doesn't translate into cheaper bling. That's because the material used in the jewelry has already been purchased by the jeweler, and the market for jewelry made from precious metals is not the same as the markets for raw commodities.

That said, simple jewelry made of precious metals, especially gold jewelry, can be more sensitive to price movements in the commodities markets. But "the price doesn't necessarily move up and down as quickly as the gold price," Jessica Fung, a commodity analyst with BMO Capital Markets, told MarketWatch.

Investing in precious metals: Should you do it?

For all you contrarians out there thinking about hoarding precious metals now that the prices have dropped, you might want to reconsider. If you invest in physical bars and coins of gold, silver and platinum, you'd also be wise to buy a safe and insure your mini Fort Knox, and that type of security will cut into your gains.

A better way to invest in precious metals is through exchange-traded funds. These funds, which trade on stock exchanges, can track individual commodities. ETFs typically charge less annual management fees than traditional mutual funds that invest in commodities.

There are ETFs for gold, silver and platinum. SPDR Gold Shares (symbol GLD), which tracks the price of gold, is the third largest exchange-traded fund in the U.S., with more than $44 billion in assets.

Precious-metals ETFs may soon not be the only way to bling out your portfolio in the future. A company called GemShares has filed with the Securities and Exchange Commission to offer an ETF that tracks diamond prices. Unlike precious-metals prices that are fueled in part by economic fear, diamond prices tend to rise when the economy is doing well. Diamond prices have increased this year as consumers feel better about shelling out for jewelry with bigger stones.

While it may sound fun to deck out your portfolio with precious-metals ETFs, most investors are better off with a diversified, low-cost commodities fund. Such a fund will give you exposure to the agriculture, energy and metals markets — which is important because they perform differently than the stock and bond markets — without being whipsawed by the volatile price swings of any particular commodity.

Gold is great for jewelry, but your portfolio needs more than one accessory.
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