Bullion as Investments

The precious metals that are used to make bullion have been used as investments since they were first mined, thousands of years ago. They have both practical uses, for instance to be used to make jewelry, and are also rare enough to allow them to function perfectly as currency.

Over the centuries, bullion has been used for currency, or in more recent times has had the value of currency based upon it, the gold standard in other words, but bullion is no longer used this way and is now only really used for investment purposes.

Bullion as InvestmentsAll currency is representative, meaning that its actual value for trade exceeds its intrinsic value, and this is why we have stopped making change out of silver. At one point the value of the silver became more valuable than the representative value of the coins, and if people could just buy the currency at its face value and sell it at a profit for its silver content, that just isn’t going to work for the mint or the central bank.

Governments need to produce currency that is much less costly to produce than its nominal value, and this is why we use paper currency as well as crafting coins with metals whose purchase price as an input does not add that much to the cost of minting the coins.

Coins involving precious metals are still minted, with a nominal value below or far below the value of the precious metal it contains, but even though these coins may be legal tender, people buy and sell them as investments and don’t spend the money.

This would of course be foolish as while anyone would be happy to take a coin that is worth a thousand dollars to pay for something worth considerably less, but the person exchanging the coin would be throwing money away. That isn’t the intent when one buys bullion coins.

The intent instead is to use bullion coins and bars as more stable stores of value than currency or even some other types of investments, while still allowing for a lot of liquidity. So unlike real estate for instance, one can easily buy or sell bullion, and there is no real-time lag between the intent to buy and sell bullion and the transaction being completed. Bullion isn’t quite as liquid as cash, or even most securities, but it’s close enough to have people very comfortable with this generally.

Investing in Bullion for Stability

Currency loses value over time due to inflation. Of course, if a currency becomes devalued, buying power goes up, but devalued currency means recession or worse. A properly functioning economy sees growth, and growth means inflation.

Bullion does serve to protect against inflation for the simple reason that its price appreciates more than inflation on average.

There is nothing special about bullion that allows it to function this way, and many other investments outperform inflation, the stock market for instance, although bullion maintains its value much better in the face of poor economic performance.

If the economy is strong, bullion will appreciate from money supply growing, as is the case with many investments. The more money there is to invest generally, the more people have to buy bullion for investments as well as for other purposes, jewelry for instance.

So, bullion gets a proportionate amount of additional investment as income rises and money supply rises, but during periods where growth is slowed or even pulls back, this is where bullion really shines.

The reason is that people will move out of investments such as stocks which are tied to the business cycle, the equities market, and even move out of debt securities such as bonds, real estate, and just about every other type of investment.

Bullion is not tied to business cycles though and performs best price wise in times of economic difficulty or uncertainty, due to people moving out of other investments and into the safe haven of bullion, especially gold bullion.

While precious metals definitely do go through the same ebb and flow that other investments do, bullion investment does present the advantage of being more stable in the face of economic downturns, where many investors move to the greater safety and stability of bullion in these situations.

What Really Makes Bullion Investing Different

This all is a self-fulfilling phenomenon, as the reason why bullion is so stable is simply because more people invest in bullion when other investments that are tied to the business cycles get liquidated due to their not performing that well in these situations.

While some investments are at least loosely tied to the intrinsic value of the underlying asset, a share in the profit stream of a company for instance with stocks, the intrinsic value of bullion doesn’t really amount to very much, at least if we understand intrinsic value apart from the demand for it.

The market value of precious metals is mostly based upon their rarity and their desirability, and if you have a pound of gold versus a pound of a much cheaper metal like iron, while gold has its industrial purposes, other metals have similar or even more utility. Even with jewelry, gold isn’t particularly durable, and jewelry made out of steel for instance could be seen as having more value apart from the fact that people desire gold jewelry a lot more and are willing to pay a lot more for it than cheap trinkets made with common metals.

With bullion, it’s all about what the demand is, and this demand is far from a fad, as it goes back thousands of years, to the dawn of commerce itself.

If one bought an ounce of gold 3,000 years ago for instance, one would have seen it appreciate throughout this time, and that’s as tried and true of an investment as they come. This is likely to continue into the future as well, especially as we extract more and more precious metals and the extra supply reduces.

If income continues to rise as it is expected to, this means more demand and less supply, and this is essentially why bullion prices rise over time.

It’s Always About Timing

This doesn’t mean that the overall expected return with bullion is anywhere near what could have been achieved with stocks, or even bonds. Historically, stocks and even bonds have produced a much higher return on investment long term than bullion has, although the distinct features of bullion investment serves to add some desirable features to one’s portfolio.

If we look at $10,000 invested in gold, bonds, and stocks over the last 200 years, adjusted for inflation, well someone went to the trouble of calculating all this, and if you put it all in gold you would now have $26,000. Investing this money in bonds would return $8 million, and with stocks, not that stocks were that widely traded all that long ago, this investment would now be worth over $5 billion.

200 years is a long time to wait for a 260% return on investment, although in recent years it’s not that uncommon for gold to have doubled in value or more if you owned it at the right time. It’s not that precious metals don’t see their pullbacks as well, as for instance if you bought an ounce of gold in 1980, and held it for 20 years, you would have paid roughly $2000 for it and sold it for less than $400. When you add inflation into this it’s even worse.

So, while investing in bullion and especially in gold is something that all investors should at least consider, bullion investing should never be seen as an all or nothing thing, were one just invests in gold or silver or platinum or palladium or some combination, and sit back and wait to get rich.

It’s all about opportunity cost with investments, and as your money may have done better in a different investment, we need to take that into account. If we have made a 50% return on investment over a certain period of time and an alternative investment would have returned 100%, we can consider this investment to have made 50% in real terms but yielded a similar loss in opportunity cost.

A pretty strong argument could be made that bullion really isn’t a good long-term investment in itself, and either needs to be timed properly or used as a hedge. With hedging we’re only looking to offset losses in other investments, a sort of insurance against losses, where we look to recoup some of these losses by holding an investment that behaves differently from our other investments.

This is the case generally speaking, apart from timing the markets for particular precious metal assets. For example, if you bought gold back in the early part of the 21st century, as the price bottomed and start to rise, it is roughly worth 3 times that amount today, which is a nice return to be sure. If you sold around the time it peaked in 2012, you would have done even better. Even long-term investments certainly benefit from timing, and bullion certainly does.

These moves aren’t typical and they are purely based upon market timing, whereas if one just took a buy and hold strategy with bullion, this is where a pure investment in it isn’t really that appealing long term.

In the medium and short term though, this is a different story, and bullion can be used quite well to accumulate capital during certain times, where it is performing particularly well. In the 4 years following the recession of 2007 for instance, gold doubled in price, although it’s rise didn’t start there.

This does involve market timing as well, and medium to short term investing always does, and this is what sets it apart from longer term investing, the idea that you’re not going to stay in this long term and you’re looking to time your entries and exits strategically.

So, bullion can indeed do well as an investment, depending on how well you invest. Just buying and holding is only a good idea long term if you’re using it as a hedge, and even then, it’s better to time it according to need.

Monica

Editor, MarketReview.com

Monica uses a balanced approach to investment analysis, ensuring that we looking at the right things and not confined to a single and limiting theory which can lead us astray.

Contact Monica: monica@marketreview.com

Topics of interest: News & updates from the Office of the Comptroller of the Currency, Forex, Bullion, Taxation & more.