I believe most investors and savers should hold up to 10% of their investible assets and personal savings in physical gold and for some high-net-worth investors a greater percentage allocation to gold may be appropriate.
Physical gold serves at least four important investment objectives:
- First, it provides a form of financial insurance should unforeseen economic or political events diminish the value or liquidity of your ordinary equity, fixed income, or real estate assets. This alone is sufficient reason to allocate up to 10% of one's investments and savings to physical gold. And, just like life insurance, your home-owners insurance, your health insurance and your auto insurance, you're happiest never collecting.
- Second, gold is the preeminent inflation hedge, offering protection against excessive monetary creation, future inflation at home and U.S. dollar devaluation in world currency markets.
- Third, it is a unique portfolio diversifier. Even though the price of gold may be, at times, quite volatile, because its price movements tend to be uncorrelated with the ups and downs in other asset prices, it reduces the volatility and price risk in one's overall investment portfolio. In other words, a portfolio including gold is over time less volatile than the same portfolio excluding gold.
- Fourth, gold's supply/demand fundamentals – especially expected growth in both jewelry and investment demand from China and India as well as increasing central-bank reserve accumulation – suggest its price will move sharply higher in the next three-to-five years – and is likely to continue outperforming most other investments, much as it has over the past decade.
Many investors confuse gold with gold-mining equities, gold exchange-traded funds (ETFs) and other "paper" gold investment products. But when I recommend holding up to 10% of one's overall investments and savings in gold, I'm talking about physical gold – bullion bars and bullion coins – that you can actually hold and store on your own or with a safe-deposit facility of your own choosing.
And, I'm talking about long-term holdings of physical gold – holding that you might sell as a last resort. If you wish to actively trade gold, speculate in short-term price movements, or bet on gold-mining shares, go right ahead – but understand that these positions should be in addition to – not instead of – your "core" percentage.
One of the main reasons to own physical gold is risk reduction – to reduce or avoid the risks that threaten ordinary investments and savings including equities, bonds, mutual funds, gold ETFs and foreign currencies.
Gold-mining equities, unlike physical gold, do not lower risk but actually subject the investor to a myriad of risks not associated with ownership of the physical metal. These include:
- Management risk – the risk that company executives and directors will make poor decisions and mismanage the companies business. This includes diversification away from gold to other mineral mining or
- Stock-market risk – the risk that a swift decline in equity prices (such as the "Flash Crash" of May 2010) will drag gold-mining shares lower along with everything else.
- Exchange risk – the risk that stock exchanges close or trading is suspended due to terrorism, natural catastrophe, computer hacking, or government mandate.
- Political or country risk – the risk of nationalization of mining assets (as occurred in recent years in Venezuela and is now threatened in South Africa, Mongolia and some South American countries) or the imposition of hostile government regulations, including environmental regulations, that increase costs and slow development of new and existing mines.
- Tax risk – the risk that mines may be subject to excessive or punitive taxation as illustrated by the recent Obama budget proposals calling for a five-percent royalty on revenues from all domestic US mining activities.
- Cost inflation – although gold is an inflation hedge, mining companies are subject to rising costs for energy, labor, steel, chemicals and other inputs.
Historically, some investors have preferred gold-mining equities to the real thing, simply because they offered leveraged exposure to the gold price. When gold prices went up, gold-share prices generally went up more.
But in recent years, gold-mining equities have significantly underperformed. When gold prices rose, gold-mining equities rose less and when gold prices have retreated, the mining stocks fell even more.
While mining companies have underperformed bullion, the exploration companies, developers, and junior mining companies have fared even worse. Investors in these companies are not really investing in exposure to the gold price at all but are betting on the chance of an economic discovery or significant mine expansion. While there are certainly some exceptions, these are the companies that Mark Twain was referring to when he said "A gold mine is a hole in the ground with a liar standing next to it."
There are good reasons to believe that gold stocks will continue to underperform the metal itself:
- First, the popularity of gold exchange-traded funds (now with some 80 million ounces in gold holdings worldwide, up from virtually nothing five years ago) has attracted funds that might have previously gone into the mining stocks. I expect the ETFs will continue to successfully compete with and continue to attract investor capital that might, in earlier years, have gone into the shares.
- Second, much of the growth in gold investment has occurred in China, India and other countries where there is no popular tradition or experience with gold-mining equity investments. This has further skewed – and will continue to skew – demand in favor of physical gold.
- Third, reserve depletion – the existing mining companies are running out of gold reserves or are only able to replace mined-out reserves with new reserves that are at greater depth, are more challenging geographically or metallurgically, and are therefore much more expensive to mine and refine.
- Fourth, many gold-oriented investors do not think highly of many mining-company managements and do not want the additional risks (see above) threatening gold-mining shares.
Despite the popularity of gold ETFs, it is important for investors to understand that they do not serve as an alternative to physical investment and ownership of the actual metal.
Investing in an ETF is not the same thing as owning the physical metal. With ETFs you do not actually own the physical metal and unless you are a large institutional investor you cannot take delivery of the physical metal.
Moreover, if it is important to you, gold exchange-traded funds do not provide the anonymity that accompanies purchase and ownership of physical bullion bars and coins.
In addition, there are risks inherent in ETF ownership that are not shared by bullion bars and coins held under your personal control. For one thing, as equities traded on public stock exchanges, ETFs are subject to exchange risk and their liquidity is dependent on the exchange operating without interruption. For another, ETFs are dependent on transfer agents, depositories, and custodians all functioning honestly and as expected.