Knowledge@Wharton Finance and Investment Research Article

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No substance of value has held its allure longer than gold. It is found in prehistoric burial sites, in jewelry designs the world over and in modern-day electronic circuitry. Gold can also be found in recent investment reports noting that it topped out at more than $1,000 an ounce in mid-March, up from about $680 a year ago. Although it dipped to just under $900 late in April, it has had a tremendous run, up from $350 five years ago.

What has driven these price gains? What does gold tell us about the economy's future? Should ordinary investors buy it?

In fact, gold has not been a good long-term investment. The previous peak was about $850 an ounce in 1980. Anyone who had squirreled some gold coins or jewelry away in a safety deposit box back then would have made next to nothing over 28 years. Indeed, with inflation factored in, gold has lost value over that period. Meanwhile, an investment in the Standard & Poor's 500 index of stocks would have grown at more than 12% a year in that time -- $100 would have grown to more than $1,800.

"I don't think it's a good buy-and-hold for a long-term investment," says Wharton finance professor Franklin Allen. "Gold is quite a risky investment, so it may well go up but it can go down substantially. You can see that in the fluctuation of prices over the past 20 years."

In his bestselling book Stocks for the Long Run, Wharton finance professor Jeremy Siegel reports that a dollar invested in gold in 1801 would have grown to just $1.95 at the end of 2006, while a dollar put into a basket of stocks reflecting the entire market would have grown to more than $755,000. A dollar put into long-term bonds would have grown to more than $1,000, while a dollar in Treasury bills and similar short-term "cash" holdings would have grown to about $300.

Gold prices tend to ride a wave of investor emotion, Siegel says. Investors and speculators have bid gold prices up over the past year because they consider it a safe haven amid worries about the credit crunch, slowing economy, rising inflation and stock market volatility. "In times of financial stress, in times of inflation, when there is fear for the [currency], gold does well," he says. "Once the fears are past, gold goes back down."

An Easy Buy

Except as jewelry, Americans were not allowed to own gold from 1933 to 1975. When the ban was lifted, the government-set price of $35 an ounce was abandoned and gold soared to its 1980 peak. For many years after 1975, it was difficult for ordinary investors to trade gold. An old piece of jewelry could be sold to a pawnshop or jewelry store, but probably for far less than its true value. Some firms sold gold coins, but they often were marketed as collectibles for prices exceeding the value of the gold they contained. Once a gold stake was acquired, there was the hassle and expense of storing it.

Today, gold investing is simple. "One of the reasons gold has surged so much is it's much easier to buy than it used to be," Siegel says. Perhaps the simplest way is to buy shares of StreetTracks Gold Trust, an exchange-traded fund that can be bought and sold like any stock under the ticker symbol GLD. Each share represents one-tenth of an ounce of gold, giving the shares a price around $86.70 at the end of April. GLD investors never touch any actual gold.

Those investors have done very well, averaging annual returns of 28% over the past four years, according to Morningstar, the market data company. But Morningstar warns that small investors who dabble in gold tend to buy after prices have soared, only to get discouraged and sell after prices pull back. Assets in GLD have soared to more than $19 billion, from just $1.3 billion four years ago. "This suggests performance chasing," Morningstar warns in an analysis of GLD's pros and cons.

Another drawback, the company adds, is that profits on GLD are taxed at income tax rates as high as 28%, while capital gains on stocks and most mutual funds are taxed at no more than 15% if the investment was held for at least 12 months.

Some companies, such as The Perth Mint, owned by the government of Western Australia, sell gold to small investors in the form of certificates representing gold stored in the firms' vaults. While this is a convenient way to bet on gold prices, fees and commissions are typically higher than they are for trading GLD, especially if one trades online through a deep-discount broker.

Investors can also bet on the gold market by purchasing stocks in gold mining companies. A number of mutual funds specialize in this niche. But it is not a pure bet on gold prices, since the companies' values are influenced by the same array of factors that can affect any publicly traded company, such as confidence in a firm's management, the size of its inventory and changes in labor costs.

Finally, small investors can trade gold futures contracts on the New York Commodities Exchange. The standard futures contract represents 100 ounces of gold, while the mini-gold contract, designed for small investors, represents 33.2 ounces. Futures trading, however, is for sophisticated investors who will keep on top of their positions day by day, since futures prices are extremely volatile.

For many people, the new highs in gold prices present an opportunity to unload unwanted jewelry, and the Internet has improved on the old method of going to a pawnbroker or jeweler. "All of a sudden, it's super-hot now, with prices going up," says Wharton marketing professor Peter S. Fader.

Companies like Lippincott, LLC are advertising heavily on television and the Internet. In its GoldKit program, 20-year-old Lippincott accepts a gold item such as a ring by mail, appraises it and mails the seller a check. Lippincott pays for shipping and insurance, and supplies the mailing materials to the seller for free. Sellers unsatisfied with the price offered can return the check and get their items back with free shipping and insurance.

Businesses like this erase the stigma many people feel in dealing with a pawnbroker or jewelry store, Fader says. "Clever entrepreneurs are finding ways to tap into this higher attention to gold. There is this untapped potential out there of higher-end people who are reluctant [to peddle their gold themselves].... Whoever can go after that group and get them to overcome their resistance has a veritable gold mine."

Gold Rings and Orphaned Earrings

Currently, says Fader, there is something of a land rush on the Internet, as firms race to grab domain names containing the word "gold." The successful firms, he predicts, will be those that branch out to purchase other valuables, such as fine watches, so they can keep going even after falling gold prices cut into the market for gold rings and orphaned earrings. Some firms, he says, are working on ways to ease the guilt people feel about selling family heirlooms by making it easier to contribute sale proceeds to charity.

Advances like gold ETFs and Internet trading make gold transactions smoother. But no matter how the gold market modernizes, key features are unlikely to change, Siegel says.

Although gold is categorized as a commodity, it does not always behave like other commodities such as oil or wheat, which run out and must be continually resupplied, he says. Once mined and turned into jewelry, gold stays in the market. Hence, the supply is continually growing, helping to explain why gold prices have not gone up over the long term.

About 70% of the gold that is mined ends up as jewelry, which is a purchase consumers can easily forgo when money is tight. The other 30% is used in electronic circuitry or for other industrial purposes.

Over the long term, gold has not been much of an inflation hedge because "it is not an inherently productive resource," Siegel notes. Stocks generally do better against inflation because companies raise prices when inflation goes up, and company assets such as buildings and factories appreciate as well. Growing productivity also helps stock prices keep ahead of inflation. No such factor supports gold prices. Indeed, growing mining efficiency boosts gold supplies, holding down long-term price gains.

Allen believes a small gold holding can be appropriate for ordinary investors who want the peace of mind that can come with an asset that keeps its value even in the worst economic crisis. "If things get really bad in terms of inflation and other things, it's still going to be there for you." But he thinks gold holdings should be quite small -- just a sliver of the portion of the portfolio devoted to cash. Investors would be foolish to dump stocks in favor of gold, Allen states.

"The doom and gloomers hold gold" as a kind of insurance policy against financial disaster, Siegel adds. "I think people pay too much for that insurance policy" at today's prices, he says, suggesting that over the long run, gold investments are bound to disappoint. "I don't think it has any place in a long-term portfolio."

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