The Risks of Bullion

Physical Bullion Involves Greater Liquidity Risk

One of the drawbacks of holding physical bullion is the risk that you will not be able to sell it at a good price, or potentially, perhaps not at all. This is less the case these days with the world opening up, where now one does not really have to do much traveling to put their bullion on the market, instead of perhaps being limited to selling it in a certain geographical area.

There are still two main factors that must be considered when holding bullion and looking to sell it, which is the addition of risk that the much larger spreads we see with bullion adds and the time it takes to deliver it and settle the trade.

These are issues that are resolved quite well by trading bullion based ETFs though, but a lot of people prefer to actually hold the gold or silver or platinum or palladium, and there is certainly a cost involved.

These costs extend beyond the normal costs associated with bullion, such as insurance, storage costs, shipping costs, and so on. The spread with bullion does tend to be front loaded for the most part, with the great majority of the profits that dealers make being added to the purchase price, but in the end, when the investments are sold, the investor still must bear the full cost of the transaction.

While we can estimate the spread involved by comparing the price a dealer sells bullion for and the price that is offered to buy it, this not only will change with the market, but the spread may also widen. This means that the price of one’s investment may go down more than the market price has, if dealers deduct more from what they are willing to pay.

While the Information Age has certainly made these markets more efficient, where one can shop around the world to get the best price, there are certainly a good number of bullion investors who are not so tech savvy and may just deal locally. These local dealers, for instance one’s bank, may not even buy bullion and investors may not even have given selling it at some point much thought.

This is certainly what you would call a serious lack of liquidity, at the local level anyway. where one is simply unaware of how to move an investment. There are a lot of traveling metal dealers who make a very good living at offering people prices well below market value, and they may indeed be the only game in town if one is not aware enough of where one may sell it otherwise.

At the best of times though, physical bullion does not have anywhere near as much liquidity as other investments, and while it can certainly be perceived as an advantage to be able to hold your investment in your hands, and even keep it in your house, there is a price to be paid for this to be sure.

Bullion Prices Depend on Enough Demand

One of the real advantages of bullion is how it keeps its value over time, and this has been the case since bullion was first held as an investment, going back thousands of years, well before even the invention of money.

Bullion is also more stable than money, and the value of money can become so depreciated that it may take a wheelbarrow of it to buy a loaf of bread, as we have seen. While we don’t want to overstate these risks, especially with the way modern currencies are so tightly managed, bullion investors do take at least some comfort in this.

What we do want to realize is that bullion’s value is almost purely derived from the price that the market places on it. While bullion does have some intrinsic value, as far as its use for purposes other than investment, the investment part drives most of the value. This is especially the case with gold, which would only be worth a very small fraction of its current value if not for the fact that people invested in it.

Bullion’s long term value therefore depends on what people are willing to pay for it, which on the face doesn’t even appear to be an issue of any concern since the demand for it has been so well sustained throughout history.

What people put money into is always competitive though, and it’s just been that so far, bullion has been able to compete quite well. It very likely will continue to do so, but this is far from automatic.

The fact that bullion does involve a physical substance is both an advantage and a disadvantage, and the disadvantage part involves it not being able to be traded anywhere near as efficiently as other types of investments, particularly synthetic ones.

Many people think that bullion derives its value, or most of it, from its rarity. Rarity is one element in its valuation, as for instance rocks could never become highly valued due to their being so commonly available.

Bullion depends on both rarity and demand, and you need both, so if bullion fell out of fashion to a significant degree, and people favored other types of investments enough, then this could affect the price quite significantly indeed.

For instance, if people and institutions decided to move some of their hedging from bullion to something else, then this is going to reduce the demand for it. If they reduce this by a lot, this will cause the price of bullion to go down by a lot, far more than the usual bear markets that we see.

These things don’t happen overnight, and far from it, but many bullion investor do not pay much attention or even no attention to the markets, making the risk of such things even greater for them.

The Market Risk of Bullion

Market risk is by far the biggest risk that investors take in holding bullion, and the price of bullion can be quite volatile indeed.

Investing in physical bullion in particular involves a fairly long term commitment, especially when you consider that you’re going to have to stay in long enough to give these investments the opportunity to cover the spread, whether that be 20%, 30%, or even more.

People don’t buy bullion and then turn around and sell it tomorrow or next week or even next month, as the intention here is to hold it longer term, measured in not months but years.

There is no investment that people pay less attention to the market than bullion, less than stocks even, and people buy stocks in pretty much any weather so to speak. We can be in the midst of a huge correction or huge bear market and it doesn’t matter, people still will buy.

Most investors do have at least a vague idea of how the stock market is performing though, and this will at least temper their investing somewhat. With bullion, investors may neither know nor care where the price is headed.

So, one’s entries into the market and one’s additions to their positions do suffer from this lack of knowledge, as well as their holding of the assets. Much of this is done pretty blindly and even more so than people invest and hold stocks. A carefree approach to stocks is one thing, because stocks do tend to go up in the long term, but this is less the case with bullion, and it therefore requires more care, not less.

It is simply not wise to just pretend that market risk does not exist, or more commonly, to pretend that it doesn’t matter, but with stocks, people do tend to hedge them at least somewhat. With bullion, well bullion is usually the hedge itself, and when your hedge needs hedging, as bullion clearly does, then this is not a hedge that at can we can afford to not pay much or any attention to.

Assets that are moving in opposite directions may seem like a great idea, like for instance the moves that the gold market and the stock market have taken over the last 8 years or so, but ideally each of these types of assets should be assessed on their own merits, which would have us out of gold entirely during this time.

The goal of hedging is to reduce risk, and when your main asset is going up, seeing the hedge go the other way significantly is not in itself an advantage or desirable. Holding a hedge such as bullion over the long term requires that it provide a desirable degree of protection when needed, but we also need to hold these hedges when they may be expected to provide this hedging, and this is going to come down to the performance of the hedge at a given point in time.

We are not forced to take a static view of the hedging of anything, where all that is required is that we hold a certain percentage of our portfolio in it and forget about the rest, and this is actually a poor approach and use of the hedge.

If the stock market is tanking and bullion happens to be tanking alongside it, there isn’t much hedging going on. We do need to pay attention to bullion markets when we hold bullion, lest we just give away money during certain periods, even ones lasting decades.

Market risk with bullion is very real and can be very substantial at times as well. Many strategies involving investing in bullion do not account for market risk at all, and this can never be a sound approach to it.

If one does look to time these investments, and also time their stock investments, as well as whatever else they may be investing in, then and only then can we say that one is looking to manage market risk properly. Exposing oneself to whatever degree of loss that the market may bear isn’t managing risk well, as when we combine strategies that manage it poorly, this does not make up for the fact we are fundamentally mismanaging risk.

As it turns out, bullion can be a marvelous investment when held at the right times, and can also serve as at least somewhat of a hedge against other investments such as stocks, by way of allowing for more diversification.

Even though physical bullion investing does require longer time frames, this does not mean that we should be doing so with little or no regard for the market. Ideally though, these days anyway, we can enjoy the best of both worlds by investing in bullion by way of much more liquid bullion ETFs, which we can trade as easily as stocks. This allows the maximum amount of flexibility while at the same time saving us a lot of money in transaction costs.