It doesn't provide an income stream. You can't eat it. Three quarters of the gold mined in the world is turned into jewellery, so really its value lies only in its intangible quality of beauty. No different to a piece of art really. Art may prove to be a good investment, but art enjoys only a peripheral place in the world of financial markets. Gold, on the other hand, is very central to financial markets. Why so?
Gold is the most malleable of metals, yet it is extremely dense. Hence it can be easily fashioned into jewellery which is impressively heavy, providing some indefinable pretence of quality. It has a colour and lustre like no other metal, and it is not abundant. Ancient civilisations first mined gold thousands of years ago.
When civilisation began to trade, money was soon invented. Gold (and its cousin silver) were obvious candidates for the purpose of defining the value of money. The first gold coins were literally "worth their weight in gold". The rarity of the metal ensured gold could not be devalued by inflation. Its purity meant it could not be counterfeited.
As trade and population increased, paper money was introduced for convenience. It represented an amount of existing gold – a "gold-backed" currency. Yet still this posed problems in a world where booming trade provided wealth that was not easy to cover with an amount of gold. Hence the "fiat" currency became popular – money backed by a government promise of its value.
After the Great Depression the leaders of the world's largest economies (of which America's had become by far the largest) realised a return to a currency system backed by gold would remove catastrophic volatility from the global system. This came about after World War II in the form of the Bretton Woods agreement.
Bretton Woods was abandoned after the Vietnam War after it became apparent the US had actually printed more money than existed as gold in the government vaults. As the benchmark currency, the US dollar had enjoyed inequitable value above that of the rising economies of Japan and Germany. Currencies were thereafter officially measured against the US dollar and allowed to "float". A purely fiat system had returned.
When gold reached its peak value of US$850/oz in 1980, it was due to oil price shocks impacting on the value of the US dollar. Only a decade earlier, gold was worth US$35/oz. The oil shocks showed that the mighty US economy was indeed vulnerable, and that at the end of the day a paper promise is a paper promise.
Gold, on the other hand, is gold. It is not consumed. The late seventies saw the return of gold as the so-called "safe haven". While gold provided no income, its value could not be destroyed.
When the oil shocks ended and the US economy proceeded to boom once more, gold's appeal withered. The US dollar became a safe haven of choice, given that investment in US Treasury securities provided an income stream and a sufficiently robust level of security. The value of such securities could be undermined by inflation, but global inflation began a long slow return to comfortably low levels over the next twenty years. As a safe haven, gold became less appealing.
Gold remains extremely rare. The entire global stock of mined gold is only 155,000 tonnes – enough to fill just over three Olympic swimming pools. The rate of new gold production barely grows each year. After World War II, the world's central banks held 68% of the world's gold in their vaults. Today that figure is only 10%. (www.goldprice.org/james-turk)
The reason central banks have sold gold is to maintain the value of their currencies, or more specifically the US dollar, against which everything else is measured. By selling gold governments can then print money, without causing inflation shocks, and thus finance consumption, and an affluent "western" lifestyle. What this has meant, however, is that the "real" value of the US dollar has fallen – that which is measured as purchasing power.
By comparing the cost of the most significant commodity in the world – oil – this fall in value is apparent.
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It is thus no surprise that it is only recently that the price of gold has attempted to test previous highs once more based on the significant rise in the oil price. In the last decade central banks have been forced to sell gold to maintain the value of the US dollar. It is speculated that the fall in the price of gold from its highs in 2006 was due to such activity, which can be conducted without official account by the International Monetary Fund. (See "The How And Why Of Gold Price Manipulation", 30/08/06)
There are further means for central banks to indirectly "sell" gold, through leasing arrangements and derivative instruments. Such transactions are again difficult to account for, rendering IMF conclusions as to the amount of gold currently held as potentially inaccurate.
Gold is thus a valuable part of any investment portfolio. It is the asset which acts as insurance against what is otherwise a paper-based financial system. In a less stable world, gold is immutable.
The most straightforward way to buy gold is to buy gold. Gold can also be purchased from the same sources in the form of gold coins. Coins offer an intrinsic value – their weight in gold – as well as an extrinsic value – their value as a collectable, related to their rarity in terms of the number of coins issued.
Manufacturing gold coins and bars costs money and this is reflected on what's knows as premium over spot (cash) gold price. In general the smaller the quantity the larger the premium. Krugerrands are priced at about 5% over spot and the larger gold bars at around 2-3%. This premium differs from merchant to merchant so make sure you check prices before you buy for money can easily be saved.
Also note that a minted gold coin is the same everywhere, the weight is the only important factor. So buying a Krugerrand that was minted in 1971 is worth the same as one minted in 2000. Of course, if you start delving into antique coins then this is a totally different matter. And obviously any form of gold jewellery is an investment in gold, with a less tangible concept of extrinsic value that is "in the eye of the beholder". If an investor is interested in purchasing physical gold for fundamentally intrinsic reasons, the problem arises that such a valuable asset needs to be stored and secured. If it's gone, it's gone.
Price is really the only important point, we like to use www.atsbullion.com in London and you can either buy in person or via the mail (they offer a fully insured service). We only buy 2 or 3 at a time but if we were going to invest say £5,000+ then spending 30 minutes phoning round the larger UK dealers to get quotes (P&P included) would be well worth the effort.
One of the easiest and simple ways to buy gold is purchase Goldgrams on the internet from Goldmoney.com and Kitco.com This is a simple savings account where you open and account and deposit cash. The difference is your money is 100% backed by gold in a bullion bank in Europe. Fees are modest and fair and you can continually add to your account much like a monthly deposit savings plan. The value of your account moves with the daily price of gold. With gold prices in rally mode, the value of your account is rising much faster than an account processed in dollars or any other fiat currency. This is a much better bank for holding cash than the other kind.
Possibly the simplest and most popular way to invest in gold is via the stock market. This has been, to date, the way your superannuation fund would invest in gold. But an investment in a listed gold mining company does not guarantee a pure investment in gold. Consider the following:
(a) Most gold mining companies also mine something else. For example, Australia's largest gold miner, Newcrest (NCM), also mines copper. Thus the price of shares in Newcrest will reflect both the price of gold and the price of copper. There are, however, "pure-play" mining stocks such as Lihir Gold (LHG). Apart from the UK stocks, Beowulf Gold and Galahad, our holdings are in US and Canadian mines. For trading the actual cash price of Gold and Silver we use spread bets.
(b) Gold mining is a risky business, and different gold mines operate at different levels of cost. While the gold that comes out will ultimately be the same as any other gold, the gold miner's profit can vary. Furthermore, gold mines are often subject to shut-down for various reasons. A landslide closed Lihir's operations for some time last year.
(c) The amount of gold reserves attributed to a mining company is only an estimate. Hence the value of a mining stock will fall, even as the price of gold rises, if production falls short of expectations.
(d) Gold stock prices are far more volatile than the price of gold. The junior stocks are cheap on a per share basis with typical prices from $.50 to under $5 per share. When good news arrives on these small exploration companies the shares can move swiftly. Larger gold companies may not rally quite as quickly but are a more conservative trade with shares in an operating mining company having major resources in cash and metal reserves. As these companies progress from a junior to an intermediate (larger share priced) explorer they list their shares on the more prominent stock exchanges like Nasdaq and the American Stock Exchange (AMEX) for buyer marketing exposure. As is the case with any equity instrument, prices are driven by market perceptions of value, rather than by known value. When the gold price rallied hard in early 2006, the value of the ASX gold index rallied harder. This was a bubble at work. It is thus no surprise that the index also fell harder in the correction.
(e) Gold miners often hedge their production. They do so by selling gold forward and delivering mined gold at a prescribed later date. This protects mining companies against a fall in the price of gold, but it also means prices can be locked in at levels significantly lower than the spot price if gold is rallying. This was the case with Newcrest this year, as investors charged into the stock without appreciating the amount of pre-sold gold on the company's books.
(f) Gold miners can go broke. This usually is the case when the price of gold falls short of the cost of recovery, but can also occur if miners over-speculate. While gold hedging can stifle the profits achieved from mining, it can also enhance the profit achieved by careful use of forward sales and derivative instruments. Rampant speculation brought down Sons of Gwalia (SGW) – once the world's third largest gold company. Overhedging (where gold recovered is less than is obliged to be delivered) brought Croesus Mining (CRS) to its knees.
The end result is that investment in a listed gold miner is in no way a pure replication of an investment in gold. It is important to note, however, that some gold stocks offer dividends, providing an income stream from a commodity which otherwise does not provide an income stream.
Trading futures contracts in gold or silver is quite entirely different. They are traded on other exchanges like the New York Mercantile Comex Exchange, in London, or at the metals department of the Chicago Board of Trade. CBOT is a very large and traditional futures exchange trading fixed income products, agricultural, meats, metals and other commodities.
Foreign countries have exchanges trading gold around the clock, 24/7 including Australia, Japan, Singapore, and others. This type of trading is different than stocks as you are trading a contract (defined) in the base product itself not a stock. A standard gold futures contract is 100 ounces. A standard silver contract is 5000 ounces. Both in New York and Chicago you can trade smaller or mini-sized contracts on the internet virtually 24/7 except when they close briefly for daily settlements.
Futures trading in gold and silver are offered in the front month, the heaviest action month (not necessarily the same one) and further out months. The price movements are typically faster than stocks offering opportunity to earn or lose large amounts of money very quickly. For inexperienced traders this can be very dangerous, especially in silver which is a tiny market which can trade erratically at times. In essence for a very small amount of margin you are trading in and controlling a large valued futures contract.
For gold at $600 per ounce in a standard contract of 100 ounces the value would be worth $60,000 for one. In silver on a 5,000 ounce contract, a price of $12.00 contract value would also be $60,000. When metals prices were much lower in recent years a daily gold move of $1-2 was common; meaning the price range was $100-$200 for the day. Now with faster trading action and wider price ranges, we see moves of $8-12 in one day offering a range of $800 to $1200 for just a few hours of trading. In silver a formerly modest move of $.05 to .10 was a good day. With a penny being $50 this gives a trader a daily range of maybe $250 to $500. Now we are seeing regular silver moves of 20-30 cents a day offering $1,000 to $1500 for one daily trading session.
Traders in these markets without protective stops to contain losses can quickly find themselves on the wrong side of a fast moving trade going negative for thousands of dollars or more. This is why these futures markets are not for amateurs. With some experience and basic skills they provide advantages and should not be feared. Entering futures with no plan, experience or strong brokers is a formula for disaster. Paper trading first is mandatory for no risk practice.
To contain risk in the futures, options on those futures contracts are available. In rising rally markets like the present, a December gold or silver futures call option costs more than say 1-3 years ago. The sellers of these options are smart and normally the premium or price you must pay for your position(s) is skewed toward a seller's advantage.
With experience, even after paying the option seller a hefty premium you can still make some fine returns if you select your positions very carefully. However, you must know correct strike price, date month, time decay and when to exit with profits. Choice of month is option critical. This takes some serious effort to identify the right ingredients for a win.
If you prefer to let others trade futures for you it is possible to invest in unit shares of a professionally managed futures trading fund. This investment vehicle is much like a stock mutual fund except the fund managers are trading in futures on markets not the underlying stock or commodity.
You can also invest and trade in commodity index funds designated for gold, silver, base metals, grain, energy, cotton, cocoa, and coffee. These funds trade in very specific markets or in large groups of them. You can select your specific choice from a wide array of offerings.