There are several means by which people can invest in gold, and each has its pros and cons. While some methods may be better overall, whether or not one may be preferable over another often comes down to what would be best suited to what is looking to accomplish with the investment.
If one wishes to invest in gold as a hedge against the collapse of the economy for instance, being in possession of the physical gold would best serve that purpose, because then they would not have to worry about potential losses that may occur if the value of the investment could not be delivered to them.
We call this counterparty risk, and while there is generally always this sort of risk, even if you own physical gold. There is the risk that the company who is storing your gold will not be able to deliver it to you, or even if you have it in a safety deposit box at a bank, you may not have access to it when you need it if the bank becomes closed down or the bank may even lose it, which has happened.
If you store it yourself, it may be stolen from you, and even if the safe you keep it in is burglar proof, you still could be held up and be forced to deliver it.
Most gold bullion that is purchased by investors is unallocated, meaning that the company storing it will only keep a float to meet normal demand, where they have to rely on purchasing the gold on the spot market if the demand exceeds their supply.
Should the demand to deliver the gold spike, this could result in their not having the means to purchase it to deliver your gold to you, as they might not be solvent enough or the price may rise to the point where the value of the gold can greatly exceed the price you paid for it.
Depending on the severity of the crisis, this may mean that you may only receive a percentage of your investment back, ranging from most of the value you expected to perhaps even considerably less. This must be considered if the goal is to hedge against such crises, although it is true that less protection than you may desire may be preferable to even less if you don’t seek to protect yourself.
The Pros and Cons of Physical Gold Buying
Actually owning gold bullion or other forms of physical gold, where you actually possess the gold, or the physical gold is held by a third party in your name, does have the advantage of security where you at least have to worry less about being able to take possession of it if needed or desired.
People usually will own gold as a general hedge, not just against economic failure, but against economic downturns of a lesser magnitude as well, to be used as a buffer to reduce risk exposure of more economically sensitive investments like stocks.
Should the magnitude of the decline be of the normal sort though, where systemic failure is not a concern, as long as you either own the gold or the shares that you buy represent real ownership in gold, such as is the case with passive exchange traded funds or ETFs, then the risk of your being able to be delivered the value of your investment is not a major concern.
This is not to say that it is of no concern though, as we have seen ETFs fail in fairly modest conditions, where the assets had to be liquidated and investors lost over a quarter of their investment as a result of the business failure of the fund.
This can’t happen with owning the physical bullion yourself of course, but while this does have its advantages, it also has its costs, and investors need to seek to decide whether these additional costs are justified.
Buying gold shares, whether that be shares of an ETF or of a gold related company, are far more liquid than physical gold, and shares are also considerably more cost efficient.
The much greater liquidity of shares allows for far tighter spreads when investing in gold than if you buy and sell the physical gold. You can enter and exit positions in gold with shares in a flash, and the difference between what you paid for it and what you sold it for is usually pretty minimal.
When you buy and sell physical gold, on the other hand, you have to do so through a dealer, who will mark up the transactions significantly. ETFs buy and sell the physical gold as well, but do so in far greater quantities than individual investors do and can therefore benefit from economies of scale.
The difference between these transaction costs are huge, where with buying gold on your own you can pay as much as 20% or more, each way. A round trip trade may cost you 40% for instance, and in this case, your investment would have to return at least 40% before you even start to make money on it.
Physical gold also may involve shipping charges if the gold is sent to you, or sent elsewhere to be stored. There’s also storage costs, and while funds do need to pay these costs as well, once again, economies of scale allow for much lower costs per dollar of gold invested than if you did this on your own.
Gold Based Funds Are the Wave of the Future
It used to be that if you wanted to invest in gold, buying physical gold was the only option. If you are investing in gold as a means for capital accumulation, either to make a profit from it directly or to use it to hedge the risk of other investments in order to stabilize your portfolio, the lack of liquidity and higher costs of investing in gold bullion or coins can represent a very significant drawback.
Very large investors can manage this at least somewhat by spreading these costs out over large holdings, for instance people like Warren Buffet doesn’t have to worry about the effect of this like normal gold investors do since his holdings are measured in the billions of dollars.
For the rest of us, whose gold investments are far more modest, we do need to ensure that our costs are kept reasonable as to not to overly intrude with our returns, we can look to team up with other investors and pool our resources, such that we may have the buying power that can even exceed the world’s biggest investors.
Gold funds also can hold billions of dollars’ worth of gold, and the biggest ones own hundreds of billions’ worth. One can invest in both gold based mutual funds and gold based ETFs, and ETFs offer even more benefits than mutual funds do, as they are managed like mutual funds but trade like stocks on exchanges, making entering and exiting positions even easier and faster.
ETFs also boast lower management fees, and as they are traded directly with investors rather than through dealers as mutual funds do, the costs of trading are lower due to this greater efficiency. Some mutual funds do allow you to purchase them from the fund directly these days though, although not in a way that is quite as efficient as just clicking your mouse on a trading platform, and therefore involve greater administrative costs.
Both of these are considerably more liquid than trading in physical gold, where you have to have the gold physically delivered to you, as well as having to physically deliver it back in order to sell it.
In the meantime, prices may fluctuate, and the quicker you can sell it when you want to close a position, the less market risk you are exposed to. With an ETF, this can be accomplished in seconds, with a mutual fund, it usually occurs at the end of the trading day, depending on the time of day your order is placed, or may occur at the end of the next trading day.
With physical gold, the trade is closed generally when the gold is delivered to the buyer, which can take some real time. You also have to worry about it arriving safely, and although this usually isn’t much of a concern, but this in itself costs money, especially if it needs to be sent by armored courier.
Other Means to Trade The Value of Gold
Gold based funds are not just limited to investing in gold itself, as they may also take positions in gold futures as well as investing in stock of gold related companies, such as ones involved in gold mining.
This can present opportunities to further diversify one’s gold based portfolio, as well as seek out potential opportunities that may offer a higher potential for reward than gold itself.
The drawbacks to this though is that managed funds are more expensive to run, and funds that hold active investments both have higher transactional costs and management fees.
The biggest challenge for active funds, and this includes all actively managed funds, is the sheer size of their orders, which cannot be executed anywhere near as efficiently as orders from individual investors can.
If you are trading hundreds or even thousands of shares, you can usually do so immediately, at the market or a price close to it. When you are moving hundreds of thousands or millions of shares though, this represents a big handicap and you will usually end up paying a pretty big price for this, whether that price be inferior prices or having to execute the order over a period of days or even weeks, making the trade more difficult to time properly.
If you expect a stock to go up, you can just buy the stock and see it rise. If you are looking to place a very large order for it though, you are hoping that it won’t go up right now and you can buy it at the lower price for long enough to get the order in, or pay more for it.
Because of this, many investors seek to trade gold stocks on their own, and overall, it makes sense to trade stocks on your own generally provided that you have the ability to do so effectively. Most investors do not have this ability, although most often it is that they haven’t sought to acquire these abilities rather than just lacking the necessary talent.
Successful investing in gold related stocks can offer both the ability to hedge other stock positions as well as being able to take advantage of the bigger moves that gold stocks are often capable of, but like all stock trading, this should only be done if you have the ability and experience to put yourself in a reasonable position to succeed. Gold stocks in particular can be pretty volatile, so even more care should be exercised with them.
Overall, there are several good ways to invest in gold or speculate on the price of it, and which will be best in any given situation will depend largely on an individual investor’s goals and circumstances.
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.