The price of gold is near record highs. The precious metal, however, has a history of swift and dramatic price moves in both directions. Now isn't the time to swing for the fences; it's time to step back and consider what could go wrong. If you must buy gold, here's why a gold exchange-traded fund (ETF) like SPDR Gold Shares (GLD 1.65%), which owns physical gold, is a better choice than buying a miner.

What a run

Over the past month or so, gold, using exchange-traded fund SPDR Gold Shares as a proxy, is up roughly 11%. Giant gold miner Newmont (NEM 2.10%) is up around 14%. Mid-tier gold miner AngloGold Ashanti (AU 3.17%) is up 25%. And small miner Golden Star Resources (GSS) is up a massive 57%. This isn't a particularly unusual array of numbers, since miners tend to be leveraged to the price of gold. 

A gold miner holding up a gold nugget

Image source: Getty Images.

Essentially, larger miners benefit from greater economies of scale than smaller ones, so they usually have lower costs. A move in the price of gold doesn't impact their profitability to the same degree as it does smaller miners, where the gold price needed for turning a profit can be much higher. But once that level is reached, profits take off in a material way. Thus, the price performances above make logical sense.

However, there's an interesting twist today. Industry trade group the World Gold Council recently provided an update on the gold industry, noting that overall gold demand was down 11% year over year in the first half of 2020. There was a notable decline in the demand for jewelry (off by nearly 50%), which is traditionally a large source of industry demand. But a surge in demand for gold-based ETFs helped to offset the declines elsewhere in the industry and lifted the price of the metal toward all-time highs. In other words, this price spike is being driven by investors, not fundamental strength in the gold market.  

Go with the ETF

Here's the interesting thing: Buying a gold miner has been a great choice while gold has been rallying. The numbers above bear that out. But trees don't grow to the sky, as the old investment saying goes. Wall Street can be very fickle, and there's really no telling when the tide will turn. So at this point, with gold near record levels, it's worth treading with some caution if you want to buy gold.

The key reason is that we can see with some clarity what will happen when gold prices fall by taking a quick look at the last gold bear market. The last time gold peaked was in mid-2011, at around the levels we are seeing today. The downtrend lasted until roughly the start of 2016. Over that multiyear span, gold's value, as measured by SPDR Gold Shares, fell roughly 30%. That's a painful drop.

GLD Chart

GLD data by YCharts.

However, the chart above shows what happened to the gold miners highlighted above. The declines were much worse, because the inherent leverage in the mining business model works on both the upside and the downside. Newmont's decline was 66%, more than twice that of gold. AngloGold Ashanti's shares dropped a massive 83%. And Golden Star's stock lost nearly all of its value, falling a huge 92%. Gold's decline hurt, but the plunge in the shares of gold miners was downright brutal.

If you are looking to add gold to your portfolio today, the investment-driven nature of this rally needs to be carefully considered. When the mood eventually shifts, gold will fall, and miners will very likely fall much further. Downside protection is something you need to think about. That makes an ETF like SPDR Gold Shares the better option.

A trade-off

No investment is perfect -- you are always forced to make compromises between risk and reward. SPDR Gold Shares, or a similar gold-owning ETF, will allow you to participate if the gold rally continues. The trade-off is that you'll give up the upside potential of owning miners leveraged to the precious metal's price. However, you'll benefit from the fact that, when Wall Street changes its mind and starts selling gold, the downside of owning SPDR Gold Shares will be relatively muted compared to that of miners. Now is the time for caution, not exuberance.