Every investment appeals to emotions at some level. Behavioral economists might argue that we buy stocks to satisfy our need for security since stocks are associated with long-term growth. Bonds are a response to fear since they represent safety. Fear also drives investments in gold because gold is sold as the ultimate hedge against inflation and economic crisis in general.#-ad_banner-#

Proponents of investing in gold tell stories about how the yellow metal has fascinated societies for thousands of years and retained its value during that time. Among the arguments they make are that an ounce of gold has been able to buy the same number of loaves of bread for thousands of years, or that the price of that ounce is always enough to buy a good suit of clothes at any time in the last hundred years. In other words, they believe gold will protect wealth in any economy.

While every investment decision involves some amount of emotion, gold investors often display an unusual amount of passion about their decision. But let’s take emotion out of it and see what the numbers have to say about investing in gold as an inflation hedge.

In the chart below, we look at gold, inflation and the S&P 500 since Jan. 1, 1975, which is when gold became freely tradable in the United States. Each of the data series is set to equal 100 on the start date so we can compare their gains directly. The S&P 500 has been the big winner during that time. Gold has only shown two periods of time when it was significantly above inflation, in the late 1970s to early 1980s and since the beginning of the Great Recession in 2008.

Of course, timing is everything in the market, and those who bought gold in 2000 would argue that their recent experience is different than the long-term trends.

The next chart confirms that gold has been the investment star in this century.

An interesting point about the past 12 years is that gold rose as inflation remained very low. Remember that advocates of gold argue that it protects them against inflation, but the recent gains in gold have come at a time when inflation is low.

One of the key factors driving the price of gold higher seems to be demand. The World Gold Council reports that demand for gold has increased by 5.4% a year during the past 10 years. However, demand dropped by 3.8% in 2012, and the price of gold struggled last year.

A chart from the Council also highlights that interest rates are another factor driving the price of gold. The red line in the chart below shows the real interest rate, defined as the Fed Funds rate (a short-term rate set by the Federal Reserve) minus the rate of inflation, and the blue line is the price of gold.

While the chart may not be easy to read, it delivers a strong message: Gold prices go up when real interest rates are negative. Bull markets in gold occur when the short-term interest rate is lower than the rate of inflation.

An example always helps make economic concepts easier for me to understand. Using current data, the Fed Funds rate is 0.15% and the Consumer Price Index (CPI) is rising at a rate of 1.6% per year. The real interest rate is -1.45%, a level that indicates gold could still be in a bull market.

We could see negative rates during inflation or deflation. If inflation jumped to 15% but interest rates only jumped to 10%, then the real interest rate would still be negative (10%-15% = -5%) and that would be bullish for gold. But if the interest rate was 18% and inflation was 15%, we should expect to see a bear market in gold with positive real rates (18% – 15% = 3%).

This insight makes gold an asset that should be traded. If gold delivers the bulk of its gains only when interest rates are negative, then it should only be held when that condition is true. Stocks offer better long-term gains than gold, and in fact, gold is best looked at like the stock of a company. There will be times when a stock should be bought and times when it should be sold. For gold, there will also be times to buy and sell.

Right now, interest rates support the idea that gold remains in a long-term bull market. But until demand increases, the price of gold is unlikely to reach new highs.

Action to Take –> Think of gold as a tradable instrument rather than as a core holding in a portfolio. Remember that gold can fall for decades at a time and it is better to take profits than suffer through those losses.

This article originally appeared on ProfitableTrading.com:
If You’re Investing in Gold as an Inflation Hedge, You’re Doing it Wrong