Is gold a good hedge asset for your portfolio? The intent of a hedge asset is to protect your finances from risky situations. The higher the risk of loss, the more you might want protection to minimize the possible loss. Seldom does a hedge investment completely eliminate your potential loss. Rather, it limits how much you will lose. Homeowner insurance is a way of hedging against loss of a major asset. If a fire completely wipes out your home, insurance pays for most of the cost to rebuild but you still have some out of pocket expenses depending your particular insurance policy. You have to pay the deductible and the insurance might only pay a set amount of the rebuilding costs. But you not out all of the value of your house.
People who hedge their investments insure themselves against a negative event’s impact on their finances. However, hedging doesn’t cover every possible negative event. Your homeowner policy might insure against fire but not against an earthquake. Some people with hurricane insurance have learned the hard way that it insures against wind damage but not flooding. When you hedge an investment, it’s important to know what it protects against and what it might not protect against.
What is Gold Suppose to Hedge Against?
As a hedge, gold is not intended to be a moneymaking investment. Unlike real estate or a business, gold does not create an income stream. Gold prices fluctuate based on short-term supply and demand. Demand primarily comes from jewelry manufacturers, industry, and investors (private and government). Private investor demand for gold is mostly to hedge against inflation and armageddon events. Jewelry and industry increase the supply on hand when they believe the price of gold will go up significantly or the supply will go down.
Without an income stream, the reason gold still acts as a hedge is because it lacks credit or default risks. Gold typically reacts inversely to interest rates, which are about credit or default risks. Gold prices go up as interest rates go down. Interest rates trend go up in economic strong times and down during economy struggles. So, in a broad sense gold is a hedge against economic bad times. If your other investments perform mainly based on general economic conditions, gold can be a good hedge against investments that suffer during economic downturns. But realize that a hedge with gold is against economic growth. If your other investments prosper in a strong economy, you should expect your gold value to decrease.
Inflation is another economic condition that investors use gold as a hedge against. However, inflation and economic strength are also closely tied together. Inflation increases during strong economic times and inflation is lower during economic slowdowns. This is why the Federal Reserve uses interest rates as a broad sword to slow or increase inflation. Therefore, gold hedges against both rising interest rates and inflation.
Gold can also act as an armageddon hedge. Gold tends to react when bad things happen. It could predictions that Wall Street is going to be wiped out, global warming will destroy the economy, or news that an asteroid is about to end the world. When investor fears are at their worst, they turn to gold. But gold has limitations during armageddon. A gold coin might buy a pound of hamburger or nothing at all. That’s why preppers hedge with a bunker full of food and water.
Gold is not good against such extreme circumstances. On the other hand, it can be very valuable if it is a personal armageddon that only wipes out your personal assets. That’s when having some gold in a vault will buy almost anything you need. But if the future of mankind is troubling you, it can still make sense to sock away a little gold if it buys you some peace of mind.
Gold is One Hedge Among Others
With an understanding that a hedge is about limiting losses rather than earning profits, gold does have a role as a hedge against potential losses related to riskier investments. However, gold is not the only hedge strategy available.
Stock and bond hedging makes a limited example because unlike gold, both stocks and bonds can go to zero in value. Stocks and bonds tend to perform in opposite directions with stocks being the riskier investment. Periodically rebalancing a portfolio between stocks and bonds can be a hedge strategy. When stocks are perceived as high risk, reallocating part of a portfolio into bonds may be desirable (along with the inverse). Another strategy is using derivative options like Puts and Calls. But a more common strategy is diversifying across industries such as technology and energy.
Your Solo 401k offers even more hedge possibilities simply by the fact that it has an almost unlimited number of investment possibilities.
What are Other Hedge Assets?
Commodities in general are considered a hedge strategy in an uncertain economy. These are economic staples that always remain in demand although the amount of demand can change as well as the amount of supply. But there is always some level for demand. Examples of commodities are a bushel of corn, a liter of orange juice, or a pound of sugar. Hard assets, such as natural resources, gold, silver and real estate act much the same as commodities. (Stocks and bonds are “soft assets.”) A hard asset holds intrinsic value because it is naturally limited in supply (scarce).
Gold and other precious metals are an effective hedge when the economy negatively affects currencies. This when investors can incur gains from the metal’s increased value while other investments loss value. History shows this is most effective when stock markets are crumbling. Gold is also considered good for portfolio diversification because of the negative correlation to stocks, bonds, and other financial instruments.
Real estate is a hard asset and a commodity. Both land and structures serve basic needs, as well as being in limited in supply. The land itself is one commodity and a structure on the land is a separate commodity. While more buildings can be constructed, no one is making more land.
How to Invest in Gold as a Hedge
Holding some physical precious metals inside your Solo 401k can help you to truly diversify. We call this establishing a personal hedge fund. Unfortunately, it’s often overlooked even by seasoned investors. Purchasing and holding gold is one of the easiest transactions to complete. If you haven’t already, the first step is opening your Solo 401k.
Investment grade gold is known as “bullion” that is available in coins and bars. Bullion is valued by weight measured in ounces or grams. Bullion bars are usually measured in grams. Coins are the most common individual investment and come in 1-ounce or 1/2-ounce. To be investment grade, it must be refined to at least 0.9950% fineness. The purity requirement determines the places where Solo 401k bullion is purchased. Any NYMEX/COMEX approved refiner can sell you precious metals to hold inside your Solo 401k. (Collectable gold is not acceptable for a Solo 401k – more about this is below.)
Using Gold as a Hedge in your Solo 401k
Most attorneys consider the following “safe” to hold in your Solo 401k:
- American Eagles
- Canadian Maple Leaf
- Australian Kangaroo
- Austrian Phiharmonic
The same guidelines of fineness and approved refineries means you can also hold platinum, palladium, and silver inside your Solo 401k. Some attorneys believe you can only hold American Eagles in a retirement account. Always check with your legal counsel first before buying and holding metals in a retirement account.
What About Collectibles?
Collectable coins (aka numismatic coins) have price speculation. Sometimes they are worth more than their metal content but are not investment grade. These are not produced in modern times and the primarily value is based on their rarity rather than metal content. The collector market determines value, not the precious metals market. Tax code Section 408(m)1-2 clearly states that collectables are not allowed in a retirement account and any collectables purchased with retirement account funds could be considered subject to taxable distribution.
Physical precious metals like gold are an excellent long-term investment to provide a hedge against inflation, protection in a currency crisis, or even as a sound investment that has proven to go up over the long term.