When can gold offer a good investment hedge?
As the economy and financial markets begin to recover from the COVID-19 pandemic, experiencing similar market risk in future has become a large concern for many investors. Specifically, the risk of inflation and loss of purchasing powerhas become the concern for many investors.
There are numerous ways to try and protect yourself against market risks, but one of the most favoured is investment hedging. Hedging is a strategy that aims to protect an individual’s finances from being exposed to risks that may lead to adverse price movements in an asset class. Despite this strategy being effective, it isn’t always that a hedge investment eliminates your entire potential loss.
This article aims to explain hedging and how it works, along with focusing on how investing in precious metals can help you hedge against some of your more volatile investments.
What is Hedging and How Does it Work?
Hedging is a risk management strategy that should be understood by investors because of the protection it provides against downside risk. Hedging can be utilised to offset investment losses by taking an opposite position in a related asset class. Essentially, the aim of an investment hedge is to protect your finances from high-risk circumstances, as the larger the downside risk, the greater the importance of protection.
One of the biggest risks in investing is not being able to outperform inflation. This means that if you are invested in an asset class that is unable to deliver ideal returns and beat inflation, your investments may not produce enough to provide for your ideal retirement. Cash is a good example right now, as cash rates are earning less than inflation.
There are several types of asset classes that are known to perform well as a hedge in inflationary environments. These include what are classified as ‘hard assets’ or tangible assets,such as property, oil and precious metals. These types of assets have been historically used and seen as inflation hedges.
However, it’s important to note that when investing, having a balanced portfolio of investments in different asset classes is key. By spreading out your investments and creating a diversified portfolio, you’re putting yourself in the best position to manage risk.
Investing in Precious Metals
When investing in gold, there are countless avenues of investing to be considered, such as:
- Gold Coins
- Gold Companies
- Gold Futures
- Gold EFTs
- Gold Bullion
- Gold Jewellery
Among the various available asset classes for investment, gold is often widely used as a hedge against inflation and purchasing power. Traditionally, gold is considered a ‘safe-haven’ investment in times of economic uncertainty, and over the long term, gold has typically been able to deliver higher-than-inflation returns.
Gold is classified as a hard asset, as it is typically physical, and holds intrinsic value overtime. Since gold does not produce interest or dividends, holding the asset for appreciation purposes and to hedge against inflation becomes the main objective. When purchasing precious metals as an investment, the intent is to use it in future to create wealth, due to the increase in value over a duration of time.
During a crisis, i.e. A global pandemic, gold becomes a good asset option for hedging to absorb the shocks taken in the stock, equity, and bond markets.
However, gold may not be the best option for all. It’s imperative to consider its volatility as well as its opportunity cost.
Risks to Consider When Investing in Gold
There are both advantages and disadvantages that come along with investing, listed below are some risks you may want to consider before investing in gold:
- A long waiting period may have to be endured before profits can be realised: A large number of investors tend to enter when gold is reaching its peak, which is usually a limited time-frame, making encountering the downside more likely for these investors.
- Spikes in inflation: There is no way to guarantee above average returns in the situation of inflation.
- Whether in the physical or intangible form, investing in gold is a complex decision to make that should not be entered into lightly. If you chose to purchase gold, it is integral to ensure you’re buying from a reputable source.
When it is Suitable to Utilise Gold to Hedge Against Investments
Gold remains valuable as a means of being used as a hedge against investments, due to the fact that it lacks default risks. Although the price of gold has proven at times to be unpredictable in the short term, it has been seen to consistently maintain its value in the long run. This logic tends to prevail when inflation rises and investors come to the realisation that their money is losing value, as this is usually when they will start positioning their investments in a hard asset that is known to keep its value, such as gold.
Another instance where gold is commonly used, and arguably the most popular, is as a source of protection to hedge against a decline in a currency. In the situation of the dollar slipping, gold becomes less expensive to hold and is also subject to a rise in value.
A guest article written by James McFall from Yield Financial Planning.