Gold Investing 101
Author: Adam Hamilton
Published: May 31, 2002, republished with permission.
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Synopsis: As gold's recent spectacular performance becomes more widely known, many investors new to gold are wondering how they can participate in the exciting gold action.
With gold stocks already way out in the lead in the important race to become the best performing market sector in 2002, many investors are scrambling to stake out a claim on the golden action.
While there has always been and always will be a hardcore group of dedicated, some would even say fanatical, gold investors, many non-traditional gold investors are also eager to deploy some capital into this newly red-hot sector. Just as in every other market sector, the gold arena can be quite complex and intimidating for investors who have not yet found the time to research the gold market in depth. Unfortunately many potential gold investors are probably scared away because they cannot easily find a way to begin investing in gold.
I am writing this essay with these new gold investors in mind. If you are interested in investing in gold investments for the first time yourself but are wondering just how to embark upon such a journey, perhaps you will find some useful thoughts here that will help guide you on your first step. Gold investing can be incredibly enriching on multiple fronts and I hope you find the fascinating world of gold to be as profitable as I have.
Why Invest in Gold?
The past year has been immensely impressive for the yellow metal, which I affectionately call the Ancient Metal of Kings. Gold itself is up 27% since its April 2001 low. The leading US gold stock indices have rocketed up by 105% (XAU) and 300% (HUI) since their November 2000 lows 18 months ago. Classical bull markets are usually defined as 20%+ gains over a year or more. Both gold and gold stocks are soaring upwards in strong bull markets and making fortunes for those who have deployed capital in the gold sector.
Gold is in a bull market because its core fundamentals are so outstanding. The gold price, like every other commodity or stock, is ultimately driven by supply and demand.
Each year all of the gold mines in the world combined are able to scrape about 2,500 metric tonnes of the yellow metal out of the bowels of the Earth. This mined gold supply, however, is utterly dwarfed by growing global demand for gold. The best estimates today indicate that the whole planet buys 4,000 to 5,000 metric tonnes of gold each year. Global gold demand exceeds global gold supply by 60% to 100% annually creating an acute structural shortage situation.
For many years various central banks around the world, other countries’ equivalents of the US Federal Reserve, were willing to sell enough gold into the open markets to more than cover the huge structural supply deficit between mined supply and world demand. For most of the time since the mid-1990s this marginal supply of official gold flowing from central bank vaults was enough to more than offset the gold deficit each year, keeping gold prices from rising to fundamentally resolve its structural deficit. Since early 2001, however, the gold price has been relentlessly running higher indicating that central banks are no longer selling enough gold to make up for the global demand above the mined supply each year.
In Economics 101, an important course prerequisite for Gold Investing 101, centuries of evidence inarguably prove that a shortage inevitably leads to higher prices. In order to make up the enormous structural gold deficit each year, the gold price will have to rise far higher. Higher gold prices will ultimately entice gold mines to bring more gold production online, increasing mined gold supplies years from now. The higher gold prices will also eventually retard gold demand. Ultimately years in the future a new equilibrium gold price will be reached where global mined gold supply equals global gold demand at a new higher gold price.
The primary fundamental strategic reason to invest in gold at this particular moment in history is to ride the already in progress re-pricing of the Ancient Metal of Kings to a higher price level where supply and demand meet and offset one another and eliminate the gold shortage.
The more you investigate gold the more bullish factors you will discover, but all reasons for investing in the seemingly magical yellow metal ultimately distill down into positively bullish supply and demand fundamentals.
The Gold Investing 101 Portfolio
There are actually many ways to invest in gold to take advantage of its bullish fundamental situation. You could buy gold itself, buy gold stocks, or buy gold derivatives. Just as in any other sector, there are abundant gold investment possibilities out there to meet the unique risk tolerance and capital deployment of any potential gold investor.
Before you invest in gold, you should carefully consider what percentage of your overall portfolio you wish to risk in gold-related investments. If you are totally new to gold and are just getting your feet wet, perhaps an allocation of under 5% of your capital will be a great plenty. Later on, as you investigate gold and become more familiar with the gold world, you can increase your capital allocation to gold investments if you feel compelled to do so.
The following chart is but one sample of dozens of ways to construct a potential gold investing portfolio. It applies only to the percentage of your total portfolio that you wish to deploy into gold-related investments, not to your overall investing portfolio. For instance, if you perform your own due diligence and find that you wish to deploy 10% of your total capital into gold, the following divisions are one possibility for just that 10% of your total portfolio, 100% of the gold-related portion of your investments.
The Gold Investing 101 portfolio is structured as a simple pyramid, with the foundational base dealing with the lowest risk gold investments and the pinnacle of the structure the very highest risk gold speculations. The higher you travel up this gold pyramid, the higher are both your risk and potential rewards.
In the most basic sense, gold-related capital deployments can be classified as insurance, investments, or speculations.
The insurance portion of gold you own forms the foundation of your portfolio. It is a very low risk holding that also has the lowest potential rewards. On top of the insurance the meat of your gold portfolio can be deployed in quality gold mines engaged in the business of mining gold from the belly of the Earth. Finally, at the very apex of your gold portfolio a small bit of capital can be deployed in pure speculations if you have the means and temperament necessary to be a speculator.
Just as investing in any market sector, you can significantly minimize your company-specific risk if you diversify across the best companies in the sector. Some of the greatest investment wisdom ever uttered in history came from the lips of ancient Israeli King Solomon extolling the importance of prudent portfolio diversification. Diversification applies both across an entire portfolio and within the fraction of a portfolio deployed in a single sector like gold.
“Cast your bread upon the waters, for you will find it after many days. Give a portion to seven, or even to eight, for you know not what disaster may happen on earth.” Ecclesiastes 11:1-2, King Solomon, ca 1000 BC
Diversifying both decreases the potential risk and dilutes the potential rewards of a portfolio but it is absolutely necessary in our chaotic world if you consider yourself an investor. An investor is someone carefully deploying precious capital that is very important to them. An investor expects to prudently sow capital in the hopes of a reasonable harvest much later. An investor is dealing with crucial funds such as retirement or college money that cannot be lost. If you are considering deploying capital into gold on which you would shed a tear if it were to disappear, you probably want to concentrate on the lower half of the gold portfolio pyramid to match your investing goals.
On the other hand, there are also sophisticated financial players out there known as speculators. A speculator lives and breathes risk and is deploying capital that is not crucial to them in the grand scheme of things. Speculators, who are ultimately gamblers, are fully willing to take big risks for big potential rewards. They don’t worry at all if they lose money as they know that is simply the price of playing the game. If you are approaching gold from a speculation mentality with capital you can afford to lose if things turn sour, you can probably focus on the top half of the gold portfolio pyramid.
If you are new to the gold arena, please carefully search your soul and determine if you want to approach gold capital deployment as a conservative investor or a daring speculator. One choice or the other will totally change your approach to playing the gold market.
In this essay I will discuss gold investing itself, and in a follow-up essay in the future called “Gold Stock Investing 101” I will delve into the rest of the pyramid including gold stocks and derivatives.
Physical Gold: The Ultimate Foundation of a Gold Portfolio
The strong and heavy base of the portfolio pyramid above is actual physical gold. If you have never had the privilege of holding a couple dozen gold coins in your hands and feeling their cold weight and mystical allure, boy are you ever in for a treat when you buy your first gold! Something deep back in your subconscious mind clicks when you first handle gold and you instantly understand why so many kings, adventurers, rogues, and common folks have lusted after the yellow metal through the millennia. It is an awesome experience!
Gold is the insurance part of a gold-related investment portfolio because gold itself will always maintain at least some value, no matter what “disaster may happen on earth” as King Solomon warned. Gold may rocket up to thousands of dollars per ounce in the coming gold rally or it may struggle and fall lower, but it will always be worth something.
As the NASDAQ bust has painfully taught us all, any stock, no matter how mighty it seems at the time, always has the potential to plunge to zero. This will never, ever happen with gold, which has timeless self-intrinsic value not contingent on someone else’s mere promise to pay. Chances are any gold you buy today will be able to command at least the same amount of real goods for your great grandchildren a century or more into the future as it does today.
The values of all other financial instruments change, but gold itself is immutable and unchanging and will always hold real value.
Gold Investing in a Nonlinear World
The primary reason to own physical gold is to protect a core portion of your portfolio from all kinds of nonlinear contingencies.
We humans generally become complacent as investors and assume that tomorrow will be just like today. History has proven that linear assumptions are one of the most dangerous and lethal errors that investors can make. Even in fairly normal life we are all aware of local nonlinearities including hurricanes, tornadoes, and earthquakes. Financial nonlinearities also abound, such as the implosion of the great NASDAQ bubble in early 2000. Gold is the perfect investment to protect a foundational portion of your portfolio from an inherently unpredictable future.
Owning physical gold in your own possession is like having fire insurance on your house. Almost every homeowner in America owns fire insurance on their home. I bet you do too. Why do you own fire insurance? Are you expecting a fire? Are you planning a fire? No, of course not! You own insurance because you realize that sometimes things happen to your house that are simply beyond your control. Owning gold in your investment portfolio is like a small but crucial insurance position on your financial future.
Gold protects against all kinds of nonlinearities, from the insidious to the geopolitical to the bizarre.
For example, everyone instinctively knows that the US dollar loses value every year due to inflation. As the US Fed prints more paper dollars, relatively more money competes for and bids on relatively fewer goods and services. Think about the differences in your cost of living in 1975 as compared to today. While you may have been able to buy a house for $30k in 1975, you would probably have to pay $200k+ for the same class of house today. Gold protects against insidious nonlinearities like the gradual erosion of paper currency values through inflation. Untold financial havoc has occurred in history because people made foolish linear assumptions that the value of paper currency is sustainable.
Post 9/11, Americans are beginning to fully recognize the threat to Western Civilization posed by Islamic Fundamentalism and other religious and political sects that view the murder of civilians as a valid political tool to advance their agendas. If, God forbid, someone decides to nuke New York City or Washington DC to make a political statement, even if you can’t access your primary investment accounts for weeks or more in the aftermath, your physical gold held as insurance in your own possession will always be there to make ends meet through any terrible geopolitical nonlinearity.
Finally, in the bizarre society in which we live today, you just never know when some gold will come in handy. A computer hacker could gain access to your personal information and steal your identity, temporarily denying access to your electronic funds and accounts. Some lunkhead could trip on your sidewalk and retain a lawyer and sue you, winning an unworthy judgment on a contrived liability, and you could be faced with losing everything but your gold. The US government could find out that, horror of horrors, you accidentally squished a protected rare furry orange-striped screaming stink beetle while mowing your lawn and the EPA Gestapo could freeze your accounts while they investigated your callous act of eco-terrorism. Bizarre stuff? Certainly, but stranger things have happened to ordinary folks!
Everyone should have some physical gold around to act as insurance, just in case. You will never actually know that you need insurance until it is too late, so you have to buy gold before you think you may need it. It is very low risk and in a major bull market it could even multiply in value by more than an order of magnitude, a 1000%+ gain.
How Do I Buy Physical Gold?
The great secret of gold ownership is that the yellow metal is so incredibly easy to buy!
If you live in or near a city with a population of 15,000 people or more, check your yellow pages under “Coin Dealers” and you will find lots of listings. Most coin dealers also sell gold and silver coins to the general public. All you have to do is walk in off the street to a coin shop, write a check, and walk out with your bag of gold. It is so amazingly easy!
If you are an Information-Age investor, you can also easily order physical gold over the telephone or right off the Web. Buying gold can be as easy as ordering a book from Amazon.com. You enter your order on a webpage, input your credit card number over an encrypted secure form, and your gold can be knocking on your door in a FedEx package the very next morning. Piece of cake!
It is unbelievable how easy it is to buy gold for your portfolio! Please don’t feel intimidated for a millisecond if you wish to buy some gold for the first time.
Selling gold is just as easy. You can go see your local coin dealer and he or she will write you a check for your gold, or you can ship it off fully-insured to a company with a web-presence and they will cut you a check and mail it to you when they receive your gold. Selling gold is also quick and painless!
I have never met a gold dealer who was not extremely friendly and helpful and they are always more than happy to answer any questions for potential customers. Buying gold is as easy as buying groceries!
What Kind of Gold Should I Buy?
There are several schools of thought on this question among hardcore gold investors. Personally, I believe that you should consider buying whatever kind of gold that gives you the greatest amount of metal for the lowest possible cost. Getting the most bang for the buck is known in the gold industry as “having the lowest premium over content”.
For almost all investors, whether they are deploying $500 or $500k into gold, buying one-ounce national gold bullion coins is an ideal solution. Various countries around the world including the United States, Canada, Australia, and South Africa mint special national coins that contain one ounce of fine gold. There are slight differences between the national coins, which include the American Gold Eagle, Canadian Maple Leaf, Australian Nugget, and South African Krugerrand, but they are all outstanding coins. Your coin dealer can explain the nuances of each coin to you in great depth, but they all serve the same investment purpose.
One-ounce national gold bullion coins have several key advantages for gold investors.
First, they have a low premium over content compared to other forms of physical gold. They give you the most gold for your dollars for whatever amount of capital you wish to deploy into gold.
Second, these one-ounce national gold bullion coins are immediately recognized worldwide. If you happen to buy some Australian Nuggets on a vacation Down Under you can easily sell these very same coins later by walking into any coin store in America or the entire world. By contrast, if you were to buy gold bars, they are quite difficult to sell because the buyer has to make sure they are legitimate and their stated gold content is correct.
Third, gold coins are exceedingly easy to store. Because of their small unit nature, it is much easier to store or carry 400 one-ounce gold bullion coins than a single 400-ounce gold bar. Gold coins will also fit into all kinds of discreet hiding places around a house that are simply too small for a gold bar.
Finally, with gold coins you can easily sell any fraction of your physical gold portfolio you wish for any reason. If you buy 100 American Gold Eagles and later you need to sell to raise some cash for some expense, you can take 1, 10, or as many gold coins as you wish out of your gold investment to sell immediately. With easily divisible gold coin investments you are never stuck in an “all-or-nothing” mode regarding your physical gold holdings.
In addition to the low-premium generic national bullion coins, there is also a whole separate gold collectors’ coin world called numismatics. If you are new to gold, however, I would advise steering clear of numismatics until you have had enough time to fully research how these specialized collectors’ markets work. Gold numismatics can be excellent investments but they are far more complex and complicated than plain vanilla national gold bullion coins.
National one-ounce gold bullion coins are the perfect starting point for any new gold investor.
For additional guidelines on how to decide what kinds of coins to consider purchasing, please check out my friend Franklin Sanders’ outstanding “The Ten Commandments for Buying Gold and Silver” at: www.the-moneychanger.com
How Do I Secure Physical Gold?
Often new gold investors are worried about having any gold at home. They fear that thieves will come and liberate their gold from them. While theft is definitely a small risk, it can almost be eliminated by taking two easy steps.
First, if you are buying gold for investment reasons, tell absolutely no one about your purchase. Don’t tell your friends, don’t tell your neighbors, don’t tell your co-workers, don’t tell your kids, just be quiet about it. You could live in the most run-down shack in town and have $1m worth of gold sitting in your basement and no one outside would have a clue unless you told them about your gold investment. 95% of the chance of theft can be eliminated if you are very subtle and discreet and keep your investment absolutely private.
Even in general not bragging about any of your investments is a very wise idea as we live in a strange age full of dark greed and venomous envy where humans always seem to covet others’ possessions. Remember, you are investing to secure your own financial future and independence, not to make your friends jealous! Be discreet.
Second, even though no one except you and your coin dealer know you have any gold, be creative in hiding it. If you have 100 ounces of gold sitting on your bedroom dresser in plain sight, chances are a random thief would notice the beautiful shiny metal. But, if you think carefully and hide your 100 ounces of gold in multiple covert locations in your home or on your property, they will never be discovered by a casual invader. So few people own investment gold these days that thieves never think about it and look for other loot instead.
There are whole books written on this subject and you can be very creative here. For example, one elderly woman I used to know (she has since passed away) stuffed a dozen ounces of gold into a full jar of peanut butter in the back of her refrigerator!
If you tell absolutely no one about your physical gold investment and are very subtle and discreet about storing it, the effective risk of theft drops to near zero. Be discreet.
While physical gold in your own possession is the ultimate insurance type of investment that will weather all conceivable nonlinearities, there is also an important place in a gold portfolio for gold you own but stored with a third party. As you can see in the gold portfolio pyramid above, I classify third-party gold as a low-risk investment, not as pure insurance like physical gold in your possession.
There are many potential reasons to own third-party gold. If you have a serious amount of capital to deploy into gold, say over US$1m, chances are you will not feel comfortable storing all that gold yourself. If you are an Information-Age zealot and will only consider an investment if you can buy it with your online trading accounts, third-party gold is right up your alley. If you live in a country that doesn’t have the best record of protecting private property it often makes sense to buy third-party gold held in another stable jurisdiction with a tradition of rock-solid property rights.
While third-party gold isn’t always there in a pinch if you need it in a nonlinear crisis, it works perfectly the other 99.9% of the time. For example, some third-party gold was buried under the mountainous rubble of the World Trade Center after 9/11. If you had wanted to cash in your third-party gold right then and it was locked in those inaccessible vaults you were simply out of luck for a few weeks. But, as soon as they had access to the underground vaults again, the third-party gold was once again available on demand if you had title to some.
You can buy third-party gold at a commercial bank, at private specialized gold-holding companies, or even as an exchange-traded fund type of investment these days.
Most large commercial banks, even though they don’t advertise this service, will buy gold for your account if you make the request. For an excellent example of a real-life private specialized gold-holding company, check out my friends at Gold Heritage Certificate www.goldheritagecertificate.com . If you are a pure stock trader and want to buy a share of third-party gold with your usual stock trading accounts, consider the Central Fund of Canada, essentially an exchange-traded fund holding massive quantities of physical gold and silver listed under the symbol CEF on the American Stock Exchange.
If you do buy privately-stored third-party gold (other than CEF), make sure your gold is physically segregated and held with your name on the title, not just part of some vast gold pool with your bank’s name on the title. That way, in the worst-case scenario of the third-party bankruptcy, your bank’s creditors can’t touch your gold if it is segregated and held in your own name.
There is a whole world of excellent alternatives out there for investors who wish to invest in gold held in the custody of a third party.
Building the foundational core of a new gold portfolio is very easy for any investor today. After you decide what portion of your overall capital you would like to deploy into gold-related investments, you can easily start buying gold to form the base of your new gold portfolio.
Once you have acquired a modest position in physical gold, you will join the countless prudent investors throughout the millennia of history who always maintained a core gold position as a low risk investment/insurance just in case unforeseen events damage or impair the rest of your portfolio. The future belongs to the prepared!
After your portfolio foundation in physical gold itself is established, you may be ready to consider moving into higher risk but potentially much higher reward gold investments and speculations including gold stocks and gold derivatives. I will cover these fascinating areas in the next installment of this 101 series of essays, “Gold Stock Investing 101”.
Thank you for your valuable time and welcome to the fascinating world of gold. May your golden profits be legendary!
Adam Hamilton, CPA
May 31, 2002
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Gold coin photo courtesy of the US Mint