The Risks and Rewards of Investing in Gold

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On Jan 21st 2016, Donald Trump was inaugurated (or as pundits have said, coronated) president of the United States. Since his election and confirmation by the electoral collage, we have been busy in research. A few days ago, we published an article on the Connection Between Trump and Gold. Following up to that, we wanted to delineate some of the risks and rewards of investing in Gold today, and in the future.

Why or Why Not Invest in Gold Today?

Since the beginning of 2017, Gold has been in a favourable position. Strengthened by many of the factors outlines below, Gold, Silver, and other Precious Metals have become perceptually friendly to fearful investors. In doing so, they have defied many forces that have traditionally worked against them. Gold and these other metals carry, for example, an opportunity cost of ownership. Since Gold is not interest-bearing nor free of annual (and also includes costs for storage in physical form), you are really paying a yearly premium to own it. One way to quantify that premium is at least the interest of a 30-year treasury note, the next safest investment. Pictured below is the long-term correlation between Gold and different Assets and Currencies.

Risk and Rewards of Gold Investment - Correlation with Various Assets and Currencies

Image from the National Inflation Association

The Short-Term Argument for Gold

One correlation not described above is the correlation between US Federal Reserve overnight lending rates and inflation. In 2013, Y. S. Wang and Y. L. Cheuch showed that in the short-term, Gold and oil prices tended to rise hand-in-hand. In the long-term, as measured by prices of futures contracts, both of these were reduced by rising interest rates. Recent comments from President Trump suggest his cabinet will push to decrease the value of the dollar in relation to other currencies. This would have reaching effects for a plethora of industries. Where most exporters will benefit from such a situation, importers would suffer decreased demand for their goods.

The risks and rewards of investing in gold, in the short-term are two-fold. In the short-term, they appear to lean towards profitable rewards. First, Gold prices are classically weakened by a stronger US dollar. Second, as George Soros noted in The Alchemy of Finance, fluctuations in currency rates tend to be destabilizing generally. Neither a high nor a low dollar is as deleterious for most businesspeople as an unstable one. If the dollar begins to move around more, people will be much less comfortable keeping their money in it. This kind of uncertainty will likely increase the demand for Gold. Comments at the 2017 World Economic Forum have reflected a growing sense of de-globalization. With this would come a total economic pushback in decreased trade. Economists call this a deadweight loss and relate it to the inefficiencies of closed markets.

If the world sees a “taking things slowly” attitude prevail, Gold will likely see a presumptive push upwards in value. To understand why Gold is seen as a stable hedge during times of uncertainty, it is essential to understand what drives it. To delineate what many call a highly speculative presumption, we have outlined the classic arguments below.

5 Key Risks and Rewards of Investing in Gold.

Each point below is both a pro and con of placing your money in Gold. They are Buying and Selling Gold, the Market Value of Gold, Physical Gold Ownership, Portfolio Theory, and the Yield of Gold.

Buying and Selling Gold

Thinking about investing in Gold will lead you to a fork int he road. What is the best way to invest in Gold? Four key methods ways to own Gold are the purchase of Certificates for Gold Value, ETFs that hold the metal, Physical Gold Bullion, and Stocks of Gold Miners.

Let’s cut out Stocks as impure gold investments. You would also be investing in the company itself. Next, we are left with Bullion, Certificates, and ETFs. Each of these has a buying fee. In other words, a commission you pay to purchase it above the commodity value. Assuming you want to own physical metal, that may be a $3 to $100 per ounce premium depending on how much and what kind of bullion you’re buying. Certificates should run you upwards of 0.5% to 1.0% of the value of your purchase. Finally, ETFs will cost you around $9.99 per purchase.

At this point we can reduce the risks and rewards of investing in Gold simply. You share in it’s profits and for bullion, you have it in your hand. You can dispose of it how you please, when you please, and where you please. Note, however, that the risk here is a cost. The amounts noted above are taken on both purchase and sale by buyers and sellers at all but the largest levels. That’s why it’s so important to trust your gold buyer or seller. If you’re in Toronto, for example, you can look to our Top Toronto Gold Buyers list for help.

The Market Value of Gold

The price of Gold, i.e. the market value, is the price investors and speculators are willing to pay for it at a given time, while the market is open. What makes the price of Gold so interesting is that unlike, for example copper, it is not driven primarily by industrial demand. Despite most jewellery falling in an in-between category of semi-manufactured, the rest of Gold demand by buyers who want to own the meal outright.

Much of the market value of Gold is driven by various fears. These have to do primarily with national financial and international monetary policy. The global trend towards negative interest rates combined with Keynesian borrowing and spending are often blamed for the low yields on most investments. The more critical view is that these policies are unsustainable. They are called out as burdening North American youth with extreme national debt, and likely resulting in the systematic devaluation of paper “fiat” currencies.

What many people are speculating on is, therefore, interest rates. The cons and pros of investing in gold are therefore when interest rates go down, Gold goes up. That’s because you are essentially losing by storing your money at a bank. Combined with the other problems of owning a country’s debt (what currency is), this makes Gold much more attractive. On the one hand, if interest rates are lower than inflation, e.g. 3% and 5%, owning Gold is seen as intelligent. Gold will keep up with inflation where currency will devalue. On the other hand, if interest rates were higher than inflation, e.g. 5% vs. 3%, owning Gold would appear less profitable. The element of fear is therefore critical. If you are bearish for any range of economic, political, and social reasons on the US economy, Gold may be a safe haven to assuage your worries.

People Enjoy Physically Owning Gold

There are two rewards to owning physical Gold. First of all, people seem to love it. Most people, ourselves included, find holding a Gold bar physically rewarding. It is a cultural and historic phenomena, and there is something to be said for it. In many Asian countries, holidays and other major celebrations are filled with the exchanging of Gold and Silver. As Asia represents roughly 60% of our planet’s 7.4 billion population, that’s no small figure. In fact, China and India, together, outrank the rest of the world in overall Gold demand. R. Kannan and Sarat Dhal, looking at Indian Gold Demand over the last several decades, found price was not the overwhelming factor in demand.

Given that Gold is not getting any easier to mine, i.e. there is a constraint in supply, the price should go up over the long term. One risk of owning Gold is that if mining technology advances more rapidly than Gold demand, prices will fall, at least until demand catches up. The other risk of owning Gold is that it might be stolen, if you own bullion that is. To counter this threat, most people will either insure it or store it in an insured depository. Consider, however, how mitigating these risks costs real money.

Modern Portfolio Theory

According to the efficient market hypothesis, you can’t really beat the market. If you do, it’s because you took more risks and got lucky. Likewise, modern portfolio theory suggests that you can diversify your way out of risk. Since it measures risk as volatility “beta”, your profit “alpha” can be maximized by owning different sectors and companies. Through this diversification, you will have volatility spread throughout different areas of your portfolio.

One reward of owning Gold, and one of the principle reasons to do so, is that in worst-case scenarios, it will go up when all else goes down. With that being said, Gold can also be a generally stabilizing influence. That may not necessarily be true. Looking at the below image of the price of Gold over the last year, we find numerous spikes and downturns unrelated to global events.

Risks and Rewards of Investing in Gold - 1 Year Price

When you take off you individual hat, and put on your society hat, you may note a relationship between personal and national finance. Most countries have large Gold holdings. The top three Gold reserves in the world are: the USA (over 8.1k tonnes), Germany (over 3.3k tonnes), and the IMF (over 2.8k tonnes). By comparison, many advisors would limit individual Gold holdings to 3% or 10% on the higher end.

Modern Portfolio Theory – The Challenge

The major risks and rewards of investing in gold, inasmuch as they are associated with this sentiment are found in that modern portfolio theory. The fault is that modern portfolio thoery relies too heavily on the efficient market hypothesis. In other words, to the degree the efficient market hypothesis is wrong, modern portfolio theory is, too. Many famed investors, especially in the value and long-term minded ones, hold this to be the case. They would say you are taking unnecessary risk in over-diversifying.

That risk is the if you know what you are doing, you could make higher returns. How so? You only invest when you think there is some element of mis-pricing between current prices and intrinsic market values. This is harder to do with Gold, since estimating Gold’s intrinsic value is an exercise in reflexivity. You are trying to gauge what other people will pay in the long-term. With that challenge firmly in mind, the boon for Gold investors follows. The reward of investing in Gold, in larger amounts, is that you can really study it. If you have some lead on where the metal is headed, why bother buying investments you are either uncertain of, or that you think will just drag down your return? Of course, it would be irrational for Gold to be your only or even overwhelming asset.

The Yield of Gold

The final risks and rewards of investing in Gold lie in its peculiar profitability. In fact, Gold has a negative yield. It requires you to invest money in maintaining it, annually, and offers no dividend. Moreover, you are paying int he opportunity cost of your next best investment. With that in mind, nobody buys Gold for an annual income. That is to say, unless they are re-selling it! People buy Gold because they believe it will hedge against future downturns.

It is not irrational to hypothesize that trade will always exist, and that as the most basic currency, Gold is the automatic default. That puts a use on Gold even absent a true intrinsic value. Should people buy Gold because they suspect that it is undervalued in today’s terms? Possibly. They would argue based on the amount retrievable form the earth, discounted at a proposed rate of technological advancement, Gold may worth up to $20,000.00 per ounce.

Conclusions: The Real Risks and Rewards of Investing in Gold

Gold.TO advises you not get your expectations that high, at least not if you hope to keep the spirit of speculation at bay. What we do understand, and have seen many times, is that Gold tends to increase in value over the long haul. People who paid over 5x the price of Gold for jewellery 50 years ago, are getting back an inflation-adjusted amount of their original investment. Some people would say that Gold has had a sort of capital gain in value since then.

50 years ago, Gold was at USD 35.50/ozt. At the time of writing it was over USD 1,200/ozt. 50 years ago, the US government forbade the private ownership of Gold, and controlled its price. Given this ended in 1974, the 50-year return may in any case be misleading. Thus, the reward of owning Gold, a massive return in the case of major devaluations of the dollar is in-fact simply the store of value in case of devaluation. The risk of investing in Gold is that devaluation does not occur, and you sit on a losing investment.

 

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