Simply put, there are few (if any) areas of the financial markets that generate more confusion and elicit more polarizing opinions than gold and precious metals. A brief scan of the headlines on any given day can yield completely opposing outlooks for investment-grade precious metals, which include platinum, palladium, and silver in addition to gold. Moreover, these contrasting views are often equally intense in their convictions.
Why is there such disagreement over gold? Much of the answer lies in the blurred distinction between holding precious metals for the long haul—i.e. investing—and merely speculating on the short-term volatility of the metals. Clearing up this confusion is the most important step in determining how precious metals may fit into your long-term wealth management strategy.
Making Sense of the Noise
If you buy into the white noise that often characterizes the mainstream media, you’ll be just as likely to find pundits touting the next great bull market in gold as you are to come across the view that gold belongs in the same asset class as pet rocks.
Obviously, both perspectives can’t simultaneously be valid.
Facts are facts, however: It is true that gold is an asset that bears no interest. When interest rates are high, it’s even expensive just to hold the metal. You can see how our “pet rock” is growing rather costly while it simply sits there. So why would anyone invest in them in the first place?
The central appeal of precious metals lies primarily in their role as a safety net for an investor’s portfolio: They help balance the risk profile of one’s investments because these metals share no strong correlation with other asset classes. Gold and silver do, however, tend to perform inversely to the U.S. dollar by virtue of their status as commodities with unique monetary characteristics. (As the saying goes, you don’t see central banks holding any other kind of metals or non-perishables as reserve assets, do you?)
This is why precious metals are widely considered safe havens amid periodic economic downturns. Even with the understanding that past performance is neither gospel nor prophesy, this is precisely what happened in the aftermath of the stagflation of the 1970s and again following the financial crisis of 2008/2009. As each of the crises subsided, the trend largely continued in the reverse direction.
Ergo, even in the event that your other investments falter, a modest (perhaps 5 to 10 percent) allocation of gold and silver in addition to your mix of securities can help insure that a portion of your wealth is preserved in the form of something tangible, intrinsically valuable, and highly liquid.
This is an appropriate juncture to draw distinctions between investing in gold for the long haul and the various means for taking speculative positions on the gold price.
Forms of Speculative Gold Exposure
COMEX futures: Like most other commodities, gold futures contracts are traded on the Commodities Exchange (COMEX) division of the New York Mercantile Exchange, generally known as NYMEX. Although futures are contracts for delivery of a specified amount of gold at a later date, traders rarely take delivery of their physical metals. Instead, futures options are either settled in cash or rolled over to the next month.
Exchange-traded funds: Just like securities, shares of gold mining companies (or even shares of gold-backed funds) can be bundled into ETFs.
Shares or certificates*: In some cases, storage vaults will directly sell ownership of portions of their bullion stockpiles in the form of shares or deposit certificates, which are theoretically redeemable for a commensurate amount of precious metal. The vault or depository receives an annual fee for taking on the liability of holding the metals.
*Not to be confused with gold certificates, which were actual legal tender notes issued by the U.S. government (until 1932) that were redeemable in gold bullion.
These are all known as forms of “paper gold” in the bullion industry, and the distinction is an important one. They allow traders or shareholders to quickly get in and out of positions on gold, and offer the convenience of not having to store any physical metal yourself. It’s also true that futures trading plays a large role in determining the moment-to-moment spot price for gold.
However, the real purpose of these tools is to allow gold miners and large financial institutions to hedge their own sizeable positions; for retail buyers—virtually everyone else—these are purely speculative, short-term ventures.
According to the International Monetary Fund (IMF), gold is regarded as “the only case of a financial asset with no counterparty liability,” meaning if you physically hold it, you never have to worry about non-payment in the event of another party defaulting. This isn’t the case with paper gold. In fact, the bullion stockpile held in COMEX vaults is hypothecated (leased out), not unlike the way loans work in fractional reserve banking. This means that at the moment there are 298 times more shares or claims on gold on the COMEX than there is physical metal in its vaults. In theory, if all claimants demanded delivery of their gold at once, it could spiral into a Great-Depression-style run on the banks.
Moreover, chasing moment-to-moment or even day-to-day gold price movements fits nowhere in a reasonable plan to build and manage one’s wealth. Rather than expecting the metals to be your portfolio’s “leading scorers,” so to speak, the precious metals’ more appropriate role is as your defense, your safeguard, your backstop. By providing liquidity and a tangible asset that requires a far more modest commitment than something like real estate, gold and silver help bring versatility to your long-term financial game plan.
Everett Millman is Managing Editor and Content Writer for the Gainseville Coins blog