Note: This post is for educational purposes only and not a recommendation to invest in gold or precious metals. 

Gold and other precious metals, such as silver and platinum, are limited in supply and in great demand in many forms, including money and jewelry. They’re often considered alternative assets because their prices typically are not highly correlated with other types of investments, such as stocks or bonds.

Gold, and to a lesser extent silver, are unusual because they’re commodities but also have been used as a medium of exchange for centuries. Though paper currency is no longer pegged to the price of gold, much of the world’s gold supply is still held in reserves in the international monetary system. Precious metals are also valued for their many scientific and industrial applications, and their prices are driven not only by supply and demand but by political and economic factors, though each metal may react differently to those factors.

Why invest in precious metals?

They can help diversify a portfolio.

Because their price movements typically are not highly correlated with those of other types of investments, such as stocks or bonds, having a small portion of your portfolio devoted to precious metals may be able to help balance the performance of your other assets.

They may serve as an inflation-fighter

Precious metals, especially gold, are viewed by some investors as a way of hedging against rising prices or currency fluctuations. When inflation erodes the purchasing power of a currency–for example, if the dollar weakens relative to the euro–gold prices tend to rise. Because of this belief, gold often becomes more popular during periods of economic decline or political uncertainty.

Tradeoffs as an investment

They may experience high volatility

Precious metals is a small sector and, as a result, prices can and often do change dramatically. This volatility creates opportunities for sizable returns but also for dramatic losses.

Geographical economic/political risks can affect their prices dramatically

Sources of precious metals are concentrated in certain areas of the world, subjecting them to special risks that include:

• Unpredictable economic and political developments
• Increased environmental costs
• Changes in tax and mining laws
• Trade restrictions between countries

Metals markets involve special knowledge

The fact that precious metals investments tend to move independently of other markets means that you cannot rely on your knowledge of stocks or bonds to be a successful investor in gold or precious metals. Depending on how you choose to invest in them, understanding how those markets work may require extra attention on your part as well as experienced advice.

Bullion requires special care

Unless you invest through a dealer that holds your bullion for you, storage and shipping will require special care to prevent theft or loss. Keep your precious metals in a bank’s safe deposit box or a safe in your home. Always ship precious metals by registered mail.

Caution: If you’re considering investing in bullion, make sure you investigate the dealer thoroughly to be sure you are working with a reputable firm. This is especially true if you are considering buying online or by mail.

They are subject to the tax rate for collectibles

Net capital gains from selling precious metals (which are considered collectibles under tax law) are taxable at a maximum rate of 28 percent.

Securities vs. physical assets

You can invest in gold indirectly by buying securities whose value is based on the price of gold, or by owning physical assets such as gold bullion or coins. (Gold jewelry is typically mixed with other metals and is valued in much the same way as a gem or collectible.) Most investors in other metals prefer to invest in securities rather than physical assets because of the challenges of storage. For the sake of simplicity, this discussion will focus on gold, as it is the metal of most widespread interest to individual investors, but many of the same principles will apply to other metals-oriented securities.

Stocks of mining companies

Owning stocks in mining companies is one way to incorporate gold as a part of your portfolio. An investment in a mining company will depend in part on the fluctuating price of gold. If gold prices are up, mining companies can earn a better return on their substantial investments in land and equipment; if gold prices are down, mining companies will suffer. However, there also are many other factors to consider. As with any stock, company strategy, management and resources will affect the value of your investment, as will the market’s expectations about the direction of gold prices, the cost of mining it, and worldwide supply. In addition, the geopolitical climate may play a role.

Caution: Because of the many factors that can affect share value, investments in gold mining stocks can be more volatile than the price of gold itself.

Gold mutual funds and exchange-traded funds (ETFs)

These can be a good way to get broad exposure to gold or precious metals as an asset class. However, they require careful investigation to determine just how a given fund invests in gold. Some invest in shares of mining companies, some may invest in commodity futures contracts, some may invest partly in gold stocks and partly in bullion, and some may track an index of gold stocks. Some exchange-traded funds may own bullion exclusively, and their returns are likely to reflect the price of gold more closely than those of other funds. If you’re considering investing in a gold fund, be sure to obtain and read the prospectus available from the fund before investing so you can carefully consider its investment objectives, risks, fees, and expenses.

Options, futures and derivatives

As with any options or futures contracts, these represent a contract to deliver a given quantity of gold at a specific price by a specific time. They can be traded on margin.

Caution: If you’re considering options or futures as an addition to your portfolio, you should bear in mind that they generally require careful research and attention to market movements. Essentially, your investment depends on your being right not only about whether the value of the underlying instrument will rise or fall, but when that will happen and by how much. As a result, a gold-related option or futures contract is likely to involve greater consideration and care than investing in a stock or gold bullion. They are not suitable for all investors.

Warrants

A warrant gives the buyer the right to buy a precious metal at a given price by a given date. Unlike options or futures, however, they can usually be sold back to the issuer before their expiration date.

Bullion

You can invest in bullion in the form of bars, wafers, ingots, and coins. (Numismatic coins–old and rare coins traded by collectors–are more properly viewed as collectibles.)

Coins are the most portable, popular and liquid form of bullion. Bullion coins are legal tender coins issued by government mints and unlike numismatic coins, they have no value beyond their metal content. They generally come in one once, half-ounce, quarter ounce, and one-tenth ounce sizes. Several countries produce bullion coins. Examples of gold bullion coins include the American Eagle, the Canadian Maple Leaf, and the South African Krugerrand. Silver and platinum bullion coins are also produced.

You may take physical delivery of bullion or the seller may hold it on your behalf, issuing you a certificate to confirm ownership. Bullion can be purchased through large banks, brokerage firms, precious metal dealers, and coin dealers.

The value of bullion is determined by its weight and content or purity, as well as by the metal’s spot price (the cash price for metals that are to be delivered immediately), which fluctuates daily.

Tip: Before you invest in bullion (other than bullion coins), have the metal assayed (i.e., certified for weight and purity).