All You Need to Know About Gold

Many have asked about buying gold, so this special report comes in three parts:

1. Why gold?

2. A short Savage history of gold and the U.S.

3. How to buy gold.

Part 1. Why gold?

The allure of gold is nothing new. Throughout the centuries, gold has held a fascination that comes not only from its beauty (hold a gold coin in your hand, and you'll see what I mean), but also from its truly limited supply. That quality has always made gold a "safe haven" in troubled times. And the price of gold has been a barometer of faith in governments and the currencies they issue.

At this writing, the price of gold is around $940 per ounce. But that could change quickly -- either upward or downward -- since gold is traded around the world on a 24-hour basis. On Sept. 10, 2001, gold was trading at $271 an ounce. In March, 2008, and again last month, gold traded at more than $1,000 an ounce, just to give you some perspective. As a commodity, the price of gold is easily as volatile as stocks. But over the longer run, gold has been a reliable store of wealth.

In all of history, only 161,000 tons of gold have been mined, barely enough to fill two Olympic-size swimming pools. More than half of that was extracted in the past 50 years, and there have been few recent discoveries.

Gold can be found, but gold cannot be "created." Over the centuries, alchemists tried to create gold out of base metals, but none succeeded. Thus, the scarcity value of gold -- especially in an era where politicians create "money" out of thin air.

And that, essentially, is the argument for owning some form of gold in your investment portfolio.

Gold is not meant to be your entire investment strategy. Instead, it is designed to protect against extremes of both credit creation (inflation) and also against deflation. When asset values are falling in a deflationary period, gold bullion or coins are easily valued, and exchanged, in a global market.

Despite its history of preserving value, gold is not always priced rationally in global markets. In November, gold traded down to $725 per ounce, as hedge funds and other large investors seeking liquidity sold their gold-mining stocks and bullion, taking their profits in the one sector that had not been decimated. So gold prices are also subject to market forces.

Those who think they can preserve their wealth in gold against all economic disasters, should realize that in extreme times few would accept a gold coin in trade for the last loaf of bread. In short, if you invest in gold, you're hoping that this "insurance policy" will never really need to be used.

There is one "doomsday scenario" that encourages investors to buy gold today for future profits. Clearly, the U.S. dollar remains the currency of choice today, in spite of all the debt being created. That's partially because other global currencies are even less reliable. And the global gold market is not large enough to accommodate a rush from all dollar-holders around the world.

But if the dollar does come under attack, with foreign holders unwilling to lend us money or keep their assets in dollars, the United States could be forced to once again link the dollar to gold. Only this time, at much higher prices than the current $42.22 official price. Some are predicting a conversion price as high as $4,000 an ounce one day.

Only time will tell whether the world will repudiate the U.S dollar if we create too many of them in an attempt to bail out our economic woes. Keep an eye on the gold market for your answer.

Part 2. A short Savage history of gold and the U.S.

America has an interesting historic relationship with gold. A century ago, our country (along with England, France and Germany) backed its paper currency with gold, meaning the paper money was interchangeable with gold at an official price. Then in 1933, during the depths of the Depression, the United States went off the gold standard. The government demanded that its citizens turn in all their gold bullion coins in exchange for paper currency.

President Roosevelt's Executive Order in 1933 proclaimed a national emergency, and called for the "requisition of all privately held gold in America," with a penalty of "up to 10 years in prison and/or up to a $10,000 fine." Some numismatic, "collector" coins were exempted, but gold bullion coins and bars were confiscated.

In 1946, after World War II, global powers created a fixed international exchange rate, based on the ability of major central banks to exchange gold with the United States Treasury for a fixed price of $35 an ounce. It was called the "Bretton Woods" agreement. The dollar, implicitly backed by the gold held in Fort Knox, became the world's medium of exchange.

This system of fixed exchange rates lasted until Aug. 15, 1971, when President Nixon "closed the gold window," just as France, under Charles de Gaulle, decided that it would rather have bullion than the paper dollars that the U.S. was starting to print excessively. At the same time, Nixon imposed wage and price controls, in a fruitless attempt to control inflation, then running around 4% annually.

It wasn't until Jan. 1, 1975, that Americans were again allowed to own gold bullion coins and bars. At the time, gold was trading in global markets at around $170 an ounce. Just five years later, in 1980, amidst growing inflation fears, the price of gold rose to more than $800 an ounce.

Since August 1971, there has been no official link between the dollar and gold. Gold owned by the government was officially priced at $38 an ounce in 1972, although no foreign central bank or individual could access that gold. In February 1973, the official price was raised to $42.22 an ounce, where it remains today. Currently, the Mint says there are 143.7 million ounces of gold in Fort Knox.

The brief history lesson was necessary, I think, to understand why many feel that gold is a wise investment at a time when government is creating paper money out of thin air. They remember it was only 37 years ago, enough time for a generation to forget, that foreigners decided they didn't want to hold U.S. dollars.

Part 3. How to buy gold

There are several ways to invest in gold, and each has its own advantages and drawbacks. If you decide to purchase gold, you might want to choose several of these alternatives:

  • Gold-mining stocks or mutual funds: The advantage of buying shares of gold mining companies is that they pay dividends. That gives you a stream of income that you don't get when you buy bullion or coins. In addition, these gold mining companies are leveraged, in the nicest sense of the word. Their mining costs are fixed; if the price of gold bullion rises, they make more profits without much additional cost. You don't have to become a gold stock expert, since there are many gold mutual funds listed at Morningstar.com.
  • Gold exchange traded fund (GLD): This exchange traded fund, traded on the New York Stock Exchange, acts as a proxy for the price of gold bullion.
  • Gold bullion coins: Many countries issue gold bullion coins, including the United States, which currently issues U.S Gold Eagle coins containing one ounce of gold, and also smaller gold coins, as well as gold "Buffalo" coins. As well, you can purchase Canadian Maple Leaf coins, Australian Kangaroos and the Austrian Philharmonic gold bullion coin. All are priced based on gold bullion, with a slight premium for minting and distribution costs.
  • Numismatic (collector) coins: Older gold coins may have a collectors value and a more limited marketplace. Their value is based on rarity and the condition of the coin. Some investors remember that in 1933, most numismatic coins were exempted from confiscation, and are willing to pay a premium over the gold value to hold these coins. Again, use a reputable dealer.
  • Gold bars: You can purchase gold bullion "bars" in various sizes. One ounce is standard, but there are smaller wafers, and bars as large as 450 ounces. The problem with larger gold bars is that they should be kept in custody, to ascertain they have not been tampered with in any way. Thus, there are storage charges. And the storage provision opens the way for fraud. In the early 1980s, there were revelations of warehouses filled with bricks painted gold to look like gold bars!

And I leave you with this comment by James Dines ("the original goldbug") many, many years ago. It has stayed in my mind ever since. He said: "When my girlfriend asks for a bracelet made out of paper, I'll know paper is as good as gold!"

Terry Savage is an expert on personal finance and also appears as a commentator on national television on issues related to investing and the financial markets. Savage's personal finance column in the Chicago Sun-Times is nationally syndicated. She was the first woman trader on the Chicago Board Options Exchange and is a registered investment adviser for stocks and futures. Savage currently serves as a director of the Chicago Mercantile Exchange Corp.

More from Commodities

Watch This If You're Wondering How Much Gold to Have and When to Sell

Watch This If You're Wondering How Much Gold to Have and When to Sell

How Can Gold Continue This Upward Momentum?

How Can Gold Continue This Upward Momentum?

Week Ahead: Investors Keep Economy in Check as Trade, North Korea Talks in Limbo

Week Ahead: Investors Keep Economy in Check as Trade, North Korea Talks in Limbo

Oil Rally Steadies Even as Potential Supply Disruptions Persist

Oil Rally Steadies Even as Potential Supply Disruptions Persist

The Outlook for Gold Prices Looks Awful Even With 10-Year Yields Above 3%

The Outlook for Gold Prices Looks Awful Even With 10-Year Yields Above 3%