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How Do Gold Prices Work and Should You Buy Some?

1 ounce bullion gold coins
Piles of 1 ounce bullion gold coins are seen at the World Money Fair 2020 in Berlin, Germany. Emmanuele Contini/Getty Images

Before there were dollars or euros or yen or pesos, there was gold. For thousands of years, the beauty and scarcity of gold have made it the world's de facto currency. Gold coins were first minted in 550 B.C.E. and modern paper currencies were backed by the "gold standard" into the 20th century.

Today, investors still view gold as the ultimate "safe haven" commodity, something tangible that retains its value compared to "paper" investments like cash, stocks and bonds. That's why you'll start to see TV commercials and online ads for gold coins whenever there's fear and uncertainty about the economic future. And when demand for gold increases, the price goes up.

"Anytime there's market uncertainty caused by geopolitical uncertainty, you'll see gold prices rally," says Jim Wyckoff, senior markets analyst for Kitco Metals.

That helps explain why the price of gold skyrocketed in the first decade of the 21st century. At the close of 2000, when the stock market was soaring and the dot-com bubble had yet to burst, gold was trading at just $272.65 an ounce. But starting in 2001, with the economy in recession plus the 9/11 attacks, investors started buying up gold.

By August 2011, a few years into the Great Recession and a decade into the War on Terror, nervous investors pushed the price of gold to an all-time high of $1,917.90 an ounce.

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Should You Buy Gold in Uncertain Economic Times?

Even though gold holds its value over the long-term, especially compared to paper currencies that are subject to inflation, short-term investment in gold can be risky. Gold prices rise and fall according to global economic conditions and investor sentiment, just like stocks or other investments.

Just look at what happened in February and March 2020. As fears spread about the growing coronavirus pandemic and its effect on the economy, investors turned to gold as a safe haven, which drove the price up. On March 4, the price of gold reached over $1,700 per ounce. And logic said that as long as the stock market continued to slide, more people would turn to gold, pushing the price even higher.

But then something unexpected and far more dramatic happened. The bottom completely fell out of the stock market and a decade-long bull market turned into a vicious bear, with the Dow Jones Industrial Average plummeting more than 20 percent in a matter of days.

As investors saw their stocks take huge losses, they received margin calls from their brokers to cover any leveraged positions. To cover those margins, they needed cash and fast.

"There's an old saying in investment, 'When you can't sell what you want, you sell what you can,'" says Wyckoff. "That's what's happened with the gold market. The gold market is more liquid, so traders were able to sell some of the gold that they purchased as a hedge against stock market weakness."

From March 11 to March 16, the price of gold matched the stock market slide and fell over 20 percent.

With extreme volatility in the financial markets and crippling uncertainty in the global economy, it's a challenging time to be an investor. That said, Wyckoff fully expects the bleeding in the gold market to stop and for gold to make a rally.

"Commodities are highly cyclical in nature," says Wyckoff. "If you look at long-term charts, they go up and down sharply. That repeats itself time and time again. I suspect that in the coming years, or even this year, gold prices are going to reach all-time highs above $2,000 an ounce. That's not a bold prediction on my part, just an examination of the cyclicality of commodity markets."

Indeed, by August 4, the gold price had soared to almost $2,000 per troy ounce. Overall, for 2020, the price has been up 30 percent, according to the Wall Street Journal.

So, should you buy gold? "Buying gold as a small percentage of one's overall investment portfolio is a good idea," says Wyckoff.

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What Drives Gold Prices

One of the reasons why gold prices are so sensitive to fluctuations in demand is that the supply of gold is pretty much fixed. Gold is difficult and expensive to mine, so there's really not that much of it in circulation.

Our best estimate is that only 209,483 tons (190,040 metric tons) of gold have been mined in all of human history, and that number only increases by between 2,755 and 3,306 tons (2,500 and 3,000 metric tons) of newly mined gold a year. Compare that to steel: In just one week, the U.S. forged 1.8 million tons (1.6 million metric tons) of steel.

The price of gold is set by the London Bullion Market Association based on financial evaluations of anonymous auctions that are run every 45 seconds. There are two main prices: the gold spot price and the gold futures price. The spot price is the current price of gold. You generally buy gold at a percentage higher than the spot price and sell it for the spot price. The spot price is based on supply and demand for gold from investors, banks, etc.; market conditions as well as whether a currency is depreciating.

The futures price is a contract for the delivery of gold at a date in the future and is based on the spot price, predicted supply and demand and the cost of physically transporting the metal. Gold futures are considered highly risky (you can read more about setting the gold price here.)

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How to Invest in Gold

There are three major ways to invest in gold, each with their pros and cons:

  • Gold coins or jewelry: Buying gold coins and jewelry is one of the least expensive ways to invest in gold. Plus, this gives you a tangible asset to sell when needed. The price of coins and jewelry will fluctuate not only with the changing price of gold, but with the intrinsic value of the item. Is the coin rare or a collector's item? Is the jewelry fashionable or did it have a famous owner? Those factors will affect the gold item's price over time.
  • Gold bullion: If you have serious cash to throw around, you can buy bars of pure gold worth tens of thousands to hundreds of thousands of dollars each depending on the weight. Many people opt to pay a storage fee to keep their bullion in a secure location.
  • Exchange Traded Funds (ETFs): This is a way to trade in gold without the risk and cost of holding physical gold. Wyckoff calls these ETFs "paper gold" as they are backed by physical gold but traded the same way as stocks. The downside is that gold ETFs are high-risk investments and not for the newbie or the faint of heart.

You can purchase gold online, in some stores and, in the case of the ETFs, from an investment firm.

Last editorial update on Aug 4, 2020 11:52:38 am.

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