 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.
Third-Party Gold
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.
Conclusion
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
www.zealllc.com
May 31, 2002
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Gold coin photo courtesy of the US
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