There are a variety of ways to invest in gold, including gold bullion. However, we think the best way to invest in gold is through mining stocks—especially if their mines offer rising production and cash flow

Stocks can be analyzed with various measures of value such as the company’s earnings, dividends, sales and so on. These values change over time, but they still give you a basis for comparison. That’s not the case for gold bullion. It doesn’t produce any sales, revenue or earnings. In fact, it consumes rather than produces income, because you have to pay to insure and store it.

Unlike stocks which represent a share in a profit-seeking enterprise, gold is a commodity, and a highly specialized one at that. However, if you want exposure to that commodity, the best way to invest in gold is through gold mining stocks.

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The best way to invest in gold: What influences gold prices

For one thing, gold is the only commodity that rarely if ever gets permanently lost or consumed. This means that virtually every ounce of the metal that has ever been produced may one day come back on the market. That’s why it’s a mistake to try to predict gold prices as you would wheat prices, for example, by comparing estimates of supply and demand for the coming year.

Gold mining production is somewhat predictable, like the production of any commodity: It varies with how miners react to operating costs and market prices. Still, gold demand also depends in large part on investor psychology. Investors may choose to buy or sell gold, depending on how they feel about the outlook for the economy or inflation.

Practical matters can also influence gold buying and selling. With interest rates still at relatively low levels, investors don’t miss out on much interest income if they hold gold. If interest rates further move up, however, some investors may sell their gold and use the proceeds to buy interest-paying securities.

Because it depends on investor psychology, gold can go through huge speculative booms and busts. Gold soared in the 1970s, starting from about $42 an ounce, after the U.S. legalized gold ownership by U.S. investors. It hit a peak at around $850 an ounce in 1980. At that time, gold enthusiasts were certain that higher U.S. deficit spending—and any resulting increase in the money supply—guaranteed much higher gold prices in the coming years and decades. While federal budget deficits stayed high, gold moved downwards for the next two decades.

Gold hit a low at around $250 in April 2001. At that level, it was down more than 70% from its 1980 peak of $850. The real loss was much greater for those holding gold bullion, considering the added insurance and storage costs.

After hitting its 2001 low, gold set off on a 10-year rising trend that carried it up to $1,900. From its 1980 peak of $850 to its 2011 peak of $1,900, gold rose at an average gross annual compound rate of 2.4%. Again, that’s without accounting for storage and insurance costs or the effect of inflation.

The best way to invest in gold: What investors need to know about stocks and junior miners

Strong investor interest in gold investing increases the prices of many gold stocks, including a number of junior exploration firms that have yet to establish a history of production or cash flow. This also pushes up interest in even the most speculative juniors. Promoters then step up to exploit this interest.

In fact, when interest in gold stocks is high, some heavily promoted juniors change their focus to gold exploration simply to take advantage of investor interest in any stock that has the word gold in its press releases.

When you think about gold investing in relation to a junior firm with nothing but promise, it pays to remember that it’s far easier to create an intriguing investment opportunity than a successful exploration program.

Mind you, both tasks take some ingenuity. Both call for an injection of capital and various professional services. However, all businesses start out as investment opportunities. But few investments, particularly junior mines, turn into profitable businesses.

The best way to invest in gold is to avoid gold bullion

Under the Successful Investor approach, the best way to invest in gold is through gold stocks. We recommend staying away from buying gold bullion, coins (unless you collect them as a hobby), or certificates representing an interest in bullion.

Like bullion, gold stocks benefit from increases in the price of gold. But unlike bullion, which comes with a continuing cash drain for management, insurance and so on, gold stocks have the potential to generate income.

The best way to invest in gold: Use caution

We feel gold could well move higher over the longer term, although we expect it to remain volatile. Rising gold would mainly be driven by investor fears that still-low interest rates and government stimulus spending will spur inflation.

Conservative investors should be careful when making gold investments, as they would be with any volatile commodity investment. For these investors, gold should only make up a small part of the resource segment of their portfolios.

Regardless of what happens in the gold market, speculative and promotional gold stocks will make significant gains from time to time on hopes of a gold discovery. However, that’s always true of any sort of speculative or promotional stocks. Keep in mind that most investors who dabble in them still wind up losing money.

One controversy behind investing in physical gold is that investors can’t really know if their gold exists in a vault. How do you feel about that, and is this a reason for you to avoid gold investing?

Gold has emotional appeal, but it doesn’t always have investment appeal. If you invest in gold, have you found it to be financially rewarding? If so, under what conditions?