Physical Gold vs. Paper Gold

There are various reasons why people invest in gold, but one of them is to seek protection from so called black swan events, resulting in various degrees of economic collapse. Those who sell physical bullion for instance will widely promote the greater safety of having custodianship of actual physical gold versus having to rely on its value being delivered to you in some form, either in gold or in currency.

Table Of Contents

Physical Gold and Massive Currency Devaluation
Distinctions Between Paper Gold and Physical Gold
Risks With Allocated Physical Gold
The Risks of Non-Allocated Gold

There are a few things that we need to consider if we are seeking this sort of protection, with the first being just how likely this is to happen. We’ve never seen anything close to a true black swan event, the kind that promoters of this idea speak about, and this ever happening is pretty remote indeed, and would hold very dire consequences apart from concerns of wealth protection.

These events would be civilization ending, and having a stash of gold on hand in the aftermath would be little solace indeed. There’s also some question about how functional gold would be in such situations, as the trade of gold does require a semblance of organized economies, something that would be hard to imagine in such events.

When the world’s economies collapse, and currency becomes virtually worthless, and the means to even trade disappears, the prospects are grim and one’s survival would likely come down to a matter of just being able to take things, not so much to trade them.

The biggest problem with these views though is that the value of gold does very much depend on organized economies, the very thing that is to go away when gold allegedly becomes the only real currency. Currency requires organization though, even to be able to use it to barter, as it represents symbolic value and would lose that if we ever lost the overall market for it.

If, for instance, you were looking for food and someone had it, being able to exchange some gold for it would require that there be a market for gold overall. Without a gold market, gold really doesn’t have much value, you can’t eat it or use it for anything practical really other than to sell it to someone else.

Gold trading therefore requires a stable currency to set its value, which would not be present in completely dire events such as what is purported to offer protection. So it’s not even that these events are so unlikely to not even be worth bothering with, it’s that should this happen, the benefits of owning a lot of gold are minimal at best and likely not even very meaningful, as surviving will primarily involve other assets such as owning weapons and being able to organize a mob.

Physical Gold and Massive Currency Devaluation

If we’re looking to protect ourselves against degrees of economic collapse, such as large devaluations of currency, then holding physical gold makes much more sense.

When the value of a currency goes down, gold will at least not directly see its value go down in step, and there’s no question that gold ownership provides protection against inflation, including and perhaps especially against runaway inflation.

This is one of the main reasons why people invest in gold, to provide a hedge against more modest dips in the value of a currency or against one’s currency being devalued. It only makes sense that this protection would extend to larger or even massive dips.

When we speak of currency devaluation we are generally speaking against its losing too much of its value to inflation, where it may take much more of it to buy a certain thing than it did in the past.

Among these things which money can buy is gold though, and inflation involves a loss of purchasing power generally, which would include being able to buy less gold with a given amount of money.

Unlike a true black event, one that ends civilization as we know it as well as economies as we know them, a collapse of a currency or even collapses of currencies in general do not involve a total collapse of the means to trade, they only change the conditions of trading.

We may therefore expect gold to be of real practical value in these situations, where the gold market remains at least fairly intact if not completely so.

We now have to turn to what advantage actually being in possession of gold would represent in these situations, and this really comes down to not whether we are holding gold but whether our gold ownership represents ownership of real gold somewhere.

Distinctions Between Paper Gold and Physical Gold

Sellers of physical gold will often make the distinction between the gold they sell, which is held to be physical gold, and the so called paper gold that can be invested in with a fund for instance.

As it turns out, when you buy this paper gold, it is represented by physical gold held by the fund, and while this might not match up exactly, they are required to hold gold assets in accordance with the amount of shares they issue.

The reason why this is called paper gold is that ownership of it can be transferred by paper, and one also holds not the gold but paper that denotes its ownership. Nowadays, this is all done electronically of course, but prior to modern times, all of these transactions were completed on paper and one actually held paper denoting ownership, and the term paper has persisted.

Most of the physical gold that is bought and sold does not exist either in the metal form nor on paper though, and if there is something to be concerned about if and when major economic crisis occurs, it is this non-existent gold ownership.

We consider gold holdings as being either allocated or non-allocated, where allocated means that you are either in possession of it or it is being stored somewhere with your name on it essentially.

Funds do not allocate gold, they do have a store of it but no particular bar of gold belongs to anyone, as all investors have a fractional ownership in all the gold that the fund controls.

If you own the equivalent of an ounce of gold in a fund though, you do own an ounce of real gold in a very real sense, unlike what happens often times when you buy physical gold from a large dealer.

The Risks With Allocated Physical Gold

Dealers do ship gold to buyers, and they also will store it for you and allocate it. Even when they store it in an allocated form, there’s a risk that there may be a run on gold and you may not get yours, if the dealer both sells allocated and non-allocated gold.

This is not the case with fund held gold, as there is a singular purpose for this gold and it is held solely for the benefit of the shareholders of the fund.

With physical gold dealers though, they generally deal both in allocated and non-allocated gold holdings, and there is a risk that if things get bad enough, they may end up defaulting on their obligations to you to deliver your gold when requested.

This is noteworthy since dealers want to portray the custodial risk with funds as being a real concern, while they claim that their allocated gold does not really have any, but if their company is cast into a crisis if the price of gold rises too much, the risk of their becoming bankrupt and not delivering your allocated gold is at least on the table.

Whatever risk is involved, it is certainly higher than a fund not being able to do this, since they are not thrown into crisis if the price of gold rises sharply, and especially if it rises a great deal, the sort of thing that we’re allegedly protecting ourselves with gold investments.

The Risks of Non-Allocated Gold

Anyone who thinks that holding non-allocated gold with a dealer is in any sense not a lot riskier than holding paper gold with a fund does not understand the risks involved in non-allocated gold at all.

As long as the price of gold is stable, and as long as the so called custodian of the gold remains solvent, there are no real issues with non-allocated gold.

If and when things get truly out of hand, as would be the case with events of the magnitude that gold investing, including non-allocated gold, is supposed to protect us against, then we’re looking at a whole different story when it comes to non-allocated gold.

The real issue here is that much of this non-allocated gold isn’t even held in gold at all, it’s just held on paper, paper which merely denotes the dealer owing a certain amount of gold to you upon demand.

This is true paper gold, unlike gold in funds where there is real gold involved, and this gold just exists on paper, on a promissory note essentially. Not all non-allocated gold is just promises to buy and deliver gold to its purchasers, but a lot of it is simply this promise.

If the price goes up too much, the dealer may find themselves in a position to not be able to fulfill their obligations, and in spite of their looking to hedge their positions, this is just gold trading in essence, speculating on its future price and taking a position opposite its investors.

The more their investors gain, the less likely they will be to deliver to them. If we imagine gold going from $1200 an ounce to $10,000 for instance, and they have to buy all this non-allocated gold at this much higher price, where is all this extra money going to come from?

The answer likely is that if the price spike is significant enough and especially if it is fast enough, they will have no choice but to fail to deliver on their obligations, and they will just go bankrupt. In the face of the extreme events they claim to protect against, this fate becomes even more certain.

We might even want to say that not only does this true paper gold not protect you against huge spikes in inflation, holding your investments in these securities might be the worst thing you can do in these situations.

So, when we speak of the difference between paper gold and physical gold, the defining criteria needs to be not whether you hold gold or paper, but rather, whether the gold you hold or are supposed to hold is being held on your behalf by anyone.

If it isn’t, although this may be perfectly fine in almost all circumstances, if we’re looking to protect against the risk of the real outliers, we need to be clear on what protects us and what doesn’t, and it takes real gold to offer this protection, gold that has already been purchased, not gold that can be at some point.

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

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