first majestic silver

How to Invest in Gold

July 17, 2002

People have always been fascinated by gold. It is thought that the first example of the metal being used as coinage was around 630 BC. It was certainly minted by Darius, King of the Persians in 500 BC. Gold's inert properties not only make it an ideal store of value, but its malleability and glittering color also make it an attractive metal to use for jewelry. The relatively high value of one ounce means that it can be used to transport wealth around in times of trouble and, for this reason, it is sometimes known as the currency without borders. Gold is also regarded as a safe hedge against inflation, which tends to devalue the worth of paper assets. In view of all these qualities it not surprising that, over the years, so much effort has been put into trying to find the elusive "philosopher's stone"--a secret formula that would turn ordinary metals into gold.

Keeping gold under your bed does not, however, earn any interest. For this reason in the latter half of the 1990's it came to be seen as rather a crude investment "safe haven." It was not just investors that tended towards Lord Keynes's view that the metal was a "barbarous relic"--some central banks starting offloading significant quantities of their gold reserves onto the open market. By August 1999 the price had slumped to a 20-year low of $251 and 15 European central banks had to agree to limit their sales for five years. This announcement triggered a sharp jump in the price, but it was not long before the positive effects wore off and the price began to slide once again.

Early last year there were signs that the downtrend was beginning to bottom out as a result of the tightening market conditions. According to Rhona O'Connell, an analyst with the World Gold Council, around 70 percent of the annual demand goes into jewelry, 8 percent into the electronics industry and the remaining 22 percent is divided between production of bars and coins for investment purposes and medical use. As a result of the slump in the price, production levels have been cut back and for the last four years demand has been outstripping supply. The imbalance between the supply and demand equation was not in itself sufficient to drive prices higher. But the market was squeezed further when South African producers, who had sold their output forward on the futures market, began to unwind their hedges, starting a gentle uptrend. The move was given a sharp boost by the events of September 11th. It picked up more momentum later in the year when the Japanese, nervous about what would happen to their bank deposit accounts once the government's unlimited guarantee ran out in March of this year, went on a massive gold shopping spree. Since then the unrest in the Middle East, tensions between India and Pakistan, and the general climate of economic uncertainty have all helped push the price back up to $325--its highest level for five years.

Gold has also benefited from the fall in the dollar. The $400 billion U.S. current account deficit means that capital inflows into the U.S. have to be sustained at a very high level in order for the exchange rate to hold steady. Any let up in the rate of inward investment into the U.S. and the currency comes under pressure--which is what we are currently seeing. Should investors not only stop putting new funds into the U.S., but also begin to sell their existing U.S. assets, what has started as a gradual decline could turn into a rout. This would imply a major change of trend for the dollar and, if that were to occur, we could be seeing the beginning of a more sustained uptrend in gold because there is a negative correlation between the dollar and gold. As the graph shows, dollar peaks in 1984/85 and 1989 coincided with a periods of weakness in the gold market and more recently the dollar's strength in the late 1990's saw the gold price come under steady downward pressure.

Gold Spot Price

With the price of gold having risen so sharply, it is probably not advisable to try and start buying now in the hope of catching the coat-tails of the rally. But for those with no gold assets it is worth considering whether or not you should look at building up some exposure to this asset. The objective would be to achieve greater diversification rather than short-term gain since gold often moves in the opposite direction to not just the dollar but most other asset classes. For example, during the U.S. depression of 1929-1939, when the Standard and Poor's Index fell by 63 percent, the price of gold rose by almost 70 percent. The past 12 months has also seen the two markets move in opposite directions to each other.

Gold should, however, represent only a very small proportion of your overall portfolio. The usual advice is that it should be kept to a maximum limit of five percent. Buying when the price has just risen so sharply carries obvious risks, but any pullback would provide a good opportunity to start a policy of gradual accumulation.

The means of establishing an exposure to gold range from the simple to the highly esoteric.

The cautious long-term investor can simply buy the physical metal. A bar or coin has a guaranteed minimum purity. Retail bars in the UK tend to be 99.5% pure an are available from most high street jewelers, banks or specialist dealers. You can also buy gold coins from specialist coin retailers such as ATS Bullion. The Maple Leaf (Canadian) and the Nugget (Australian) are 99.9% pure while the U.S. Eagle and the Krugerrand are 22 carat or 91.6% purity. Coins are also available in fine gold content of one ounce, 1/2, 1/4, and a one-tenth of an ounce. The coins will cost more than the value of their gold content with the fabrication premium ranging from 3% for a one-ounce coin to 10% for a one-tenth ounce coin. Bars and coins can either be stored at home (where they need to be insured) or they can be stored at an approved vault (which will usually arrange the insurance), but this facility involves a charge of around 1.0% plus VAT. The cost of carry charges--as well as the opportunity cost of having your funds invested in an asset which does not yield any interest--need to be taken into account when considering buying the physical metal. Since January 2000, purchases of gold that are technically designated as investment do not attract VAT.

Most other methods of investment or speculation require the investor to hold an account with a broker to effect the transaction.

Mining shares are another obvious route to acquiring an exposure to gold. Mark Twain's observation during the 1849 gold rush that "a mine is a hole in the ground with a liar standing next to it" would be rather a harsh assessment in today's regulated environment. But it does highlight the risks involved in buying into any one particular company. Mines are usually located in far flung, inaccessible parts of the world, making it difficult for analysts to check out the veracity of claims. Remember Bre-X, the Canadian company whose share price rocketed up to C$28.65 in 1997 on the news that it had found one of the world's largest deposits of gold in a remote part of Indonesia, only for it to crash equally as rapidly when it transpired that the deposits were insignificant? A company's management skills, cost of production, life of the mine, rate of return, yield and currency risk all need to be assessed.

The proportion of a company's output that is sold forward will also affect the extent to which it can benefit from a rise in the spot price.

Mining is not, however, all share ramping and frauds. Over the past year while the price of gold has risen by 17 percent, the FTSE Gold Mines index has risen by 50 percent. Investing in a unit trust or fund that specializes in gold stocks helps spread the corporate risk.

Futures and options offer a more direct exposure to the price of gold than mining shares but, because of their gearing, they carry a much higher risk.

All futures markets trade on a margin. Usually it is around 10 percent of the value of the underlying contract, although some brokers require a higher initial margin. The margin system enhances returns; for example, a 10 percent move in the underlying gold price in your favour will, on a 10 percent margin, bring a 100 percent return on capital. However, should the market go against your position, the proportional losses accrue in the same way. Investors running futures positions which are showing losses at the end of the day will be "called for margin," i.e., they will be required to top up the margin held by the broker by the equivalent amount to the loss on the contract. It is therefore possible to lose more than your original margin payment.

Buying options involves a more quantifiable risk. The premium paid for buying an option takes into account its potential volatility and the consequent potential for profit. This is a function of both how long the option has to run, the volatility of the gold price and the price at which the option can be exercised. As the volatility has increase in recent months, so option premiums have risen.

Given the very short-term nature of futures and options contracts, they are not really suitable vehicles for achieving portfolio diversification. Futures trading and buying options are more appropriate for trying to capture precise shorter-term movements whereas writing options is a tool for enhancing yield during a period of relative price stability. Including gold in your portfolio is aimed at hedging risk over the long term and it is important to match a particular instrument with your investment time horizon.

During the raging bull market in equities in the 1990's, investors have did have to think about asset allocation but, in the current uncertain environment, the emphasis has switched to capital preservation and in this context it is sensible to spread risks a little more.

One cubic foot of gold weighs more than half a ton (1,306 pounds).
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