Golden rules for risk management

Owning precious metals can provide clear benefits in the form of speculative profits, investment gains, a hedge against macroeconomic and geopolitical risks and/or wealth preservation. This is one of many rules for risk management.

Successful investment is about diversification and risk management. In layman’s terms, this means not putting all your eggs in one basket. Some exposure to precious metals, especially gold, should be included in any diversified portfolio. Just as every major central bank in the world continues to hold large reserves of gold bullion, so too should private investors invest, save and own gold. A good rule of thumb would be a minimum stake of around 10 percent in physical gold and gold-related investments such as gold-producing companies or Exchange Traded Funds (ETFs).

Diversification

Gold is a unique asset class and was perhaps the first asset class to come into existence. Gold has been a store of wealth, a currency and a commodity for thousands of years. In addition, there is a growing body of research supporting the view that gold is regarded by investors as a unique asset class whose value fluctuates independently of both other asset classes and certain macroeconomic indicators such as GDP and inflation.

A number of studies abroad and a recent survey by Price Waterhouse Coopers in Australia have all found that gold is insignificantly or negatively correlated with other types of portfolio assets.

International research

Knowledge of the statistical benefits of including physical gold in an investment portfolio is slowly growing. Roy Jastramwrote the cornerstone of this research back in 1977, The Golden Constant-The English and American Experience 1560-1976. In his book, Jastram examined the price of gold and its purchasing power over time and during periods of inflation and deflation. He concluded that gold bullion has maintained its purchasing power parity with other commodities and intermediate products over the very long term.

In 1998, another financial historian, Harmston, updated Jastram’s research, looking at the relationship between gold bullion and other asset classes. Harmston studies included the USA from 1796, the UK from 1596, France from 1820, Germany from 1873 and Japan from 1880. Harmston ran a series of regressions and showed that there was a positive relationship between the annual movements in bonds and Treasury bills with the annual movements in the Dow Jones Industrial Average Index (DJI) for the period 1968 to 1996. During the same period, Harmston found that gold bars had a negative relationship with DJI.

What does this mean for investors?

It is an accepted practice in the financial industry that assets with low or negative correlation can reduce the risk of a portfolio and expand the efficient frontier, see also Markowitz’s theory of portfolio analysis. This poses a problem for most investors because most stocks are relatively correlated with each other and most bonds are relatively closely correlated with each other.

Investors therefore need to find investments that are not closely correlated to stocks or bonds and include these in their portfolios as a hedge. One of the main advantages of investing in gold bars is that gold is either negatively correlated or independent of other asset classes or financial and macroeconomic measures. There are a number of additional alternative assets that have a negative correlation with the major asset classes. Physical gold, unlike most of them, is highly liquid, exchangeable, can be easily stored and requires little handling. Research suggests that gold is one of the best asset classes for diversification.

Gold is more than an investment. It is a diversification and risk management tool – essential for a balanced portfolio

Why gold is better than cash

Right or wrong, investing in gold is often compared to investing in cash. This is partly because gold has been used as currency and money for thousands of years and is often traded as a currency, although it also has some of the characteristics of a commodity.

No matter how you choose to categorize it, gold is often regarded as a currency. Below we have summarized some of the most common misconceptions about gold versus cash, but we also show the concerns that the average person has when it comes to cash.

Defining gold versus cash

When gold is compared to cash, most people do not realize that there are two main different ways to own gold in a bank account: (1) allocated gold, and (2) unallocated gold. In accordance with this terminology, bank balances are considered as unallocated cash.

Hence, unallocated gold can be compared to bank deposits. However, it is possible to take this one step further and compare allocated gold to cash, which is what most people think of when they imagine their gold locked up in a vault where it cannot be lent out and therefore does not generate any return.

Gold has been used as money for a thousand years. Even today, it remains the ultimate currency

Allocated gold cannot be lent

One of the reasons for keeping the money in the bank is that it will – hopefully – pay an interest rate on the deposited capital, a simple return. Modern financial theory says that the higher the risk, the higher the potential return. Bank deposits earn interest because the bank then lends this money to other people and companies who need it in the short or long term.

The bank lends money at a multiple of its own capital which means that anyone who deposits money in the bank

1. takes a risk on the bank’s creditworthiness.
2. takes a risk that the bank will be able to identify those borrowers who will be able to repay their loans.

The more money the bank lends or the higher the credit risk the bank takes when lending its capital, the higher the interest rate the borrower must demand on its capital. The only way to protect yourself against this risk is not to keep the money in the bank. Similarly, unallocated gold can be lent to third parties at a lease rate.

In comparison, allocated gold is not lent, and the holder therefore bears no credit risk on the bank or on third parties. On the other hand, the holder of the unallocated gold does not receive any return in the form of a lease rate. Instead, the owner of allocated gold may pay a fee to the bank or custodian to cover the costs of storage and insurance.

The bank owns your money

Those who place allocated gold with an institution own their gold and it is possible to visit the bank and demand delivery of the physical gold. Thus, allocating gold is comparable to keeping it in your own safe.

Money deposited with the bank, on the other hand, is not owned by you. This money is owned by the bank, even if you have a claim on the bank. If the bank goes bankrupt, all the assets are distributed to the creditors (unless the bank is rescued by the state or by insurance such as deposit guarantees).

Bank deposits are considered as non-priority claims on the bank. If all bank customers who had deposited money in the bank were to demand to withdraw it at the same time, it would not be possible for the bank to meet these demands. However, in small amounts it is usually always possible to claim your money.

Gold is always accepted

Provided its authenticity has been verified, gold has always been accepted. This metal has been used as a store of wealth and as currency for many thousands of years.

Gold remains the ultimate form of currency in the world …..

Gold will always be accepted.

Alan Greenspan May 1999.

However, cash is not always accepted. A central bank can withdraw its notes and paper at any time, but gold will always be marketable worldwide. Unlike cash, it is a currency without borders. Cash has limits and this is most evident when the government is unstable, when the currency is not liquid or when the government prints too much money.

Gold is relatively rare

Without delving too deeply into the debate on whether there is a shortage of gold and whether this is what makes this metal valuable, we can point out that Gold Fields Mineral Services (GFMS) estimates that only about 150,000 tons of gold have been mined over the years. At a gold price of just below USD 1,700 per troy ounce, the global stock of gold is valued at over USD 8 trillion. To put this in context, total cash in the United States (M1 minus checking accounts) amounts to USD 1.3 trillion.

Gold is mined and produced, money is printed.

Gold requires discipline. The process takes time and from production to the minting of the finished gold bars can take as long as 30 years, although it generally does not exceed 10 years. Compare this with cash, which can be printed more or less directly by all the world’s governments and central banks.

On this issue, it may be worth reflecting on what then Governor Ben S. Bernanke said in a speech to the National Economists Club, Washington, D.C. on November 21, 2002.

Like gold, the US dollar has a value that is only limited by supply. But the US government has a technology called the printing press (or today, its electronic equivalent), which allows it to produce as many dollars as it wants at virtually no cost. By increasing the number of dollars in circulation, or threatening to do so, the US government can also reduce the value of what a dollar can buy in terms of goods and services.

Gold – bullion or shares?

Assuming you have already decided that you will own gold to diversify the risk in your portfolio, it is now time to ask yourself the next question, what type of gold should I buy? Should I buy the physical metal in the form of gold coins or bars or should I buy mining shares?

It is often recommended to hold both physical gold and mining stocks in order to maximize profits and minimize risks. Owning the physical metal has advantages over owning mining shares and vice versa, but it has been shown that a combination of these gives the best results, both protecting a portfolio and increasing its value even in difficult economic times. However, it is up to the owner of the gold to choose the allocation of their holdings, as different investors have different circumstances.

What is the difference between physical metals and shares?

The obvious difference is the level of risk. In the classical investment pyramid, physical gold is the lowest risk level together with cash, while mining stocks can be classified as belonging two or three risk levels higher if the companies produce gold, and even higher otherwise. Roughly speaking, owning the physical metal is considered a savings, while mining shares are more like a form of investment. There is an increased risk when investing in shares but with increased risk comes greater opportunity for return and thus both options should be considered.

It is also important to remember that shares in gold-producing companies are not the same as gold. It is firstly a stock, and secondly an asset with exposure to the gold market, but these stocks should never be seen as a substitute for the physical metal. Instead, these shares represent a claim on potential gold deposits in the ground and not the gold itself. Shareholdings often have inherent risks associated with investing in company shares. Shares are a part of a company, and companies often represent claims, liabilities, risks – currency, environmental, political, etc. Physical gold is the only financial asset that is not someone else’s responsibility.

Thus, owning physical gold is risk-free as long as you keep possession of the gold. Of course, the price of gold can go up or down depending on fundamentals and market fluctuations, but you can always keep it in your own hands. Physical gold does not need the cash flow or management to ensure its ultimate survival.

During a bull market, the price of the physical commodity will rise, but mining stocks will rise even more as a result of the increased price, because as the price of gold rises, profits from stocks and reserves will make mining stocks rise even more in percentage terms. Generally speaking and in the short term, it is not uncommon to see the share prices of the largest gold producers rise by a factor of two or three of the gold price in a bull market. Successful juniors and exploration companies may increase by a factor of between five and ten times the gold price.

The reason for this is that the rising gold price has no effect on the cost of producing the gold. Therefore, companies that are already profitable will gradually see their revenues from gold rise, giving them a higher cash flow and an increase in profits that will be reflected all the way down to the bottom line of the income statement. A price increase also increases the value of reserves without additional capital investment. For mining companies that are not profitable, a rising gold price could suddenly make them profitable.

It is important to determine what the purpose of an investment in gold is in order to determine the most suitable type of asset. Those who are more focused on savings often prefer to own the physical metal, while those who are more speculative prefer mining stocks. While many mining companies may periodically provide their shareholders with more or less spectacular returns and share price performance, they may also experience significant volatility.

Some other points to consider

1. Physical gold does not pay dividends. Mining shares can pay significant dividends when the company is profitable.
2. Physical gold has protected investors during periods of economic depression, war and political unrest. Mining stocks will be negatively affected in such times as stock markets may be closed or negatively affected for some time.
3. Physical gold can be used to barter or buy vital supplies in times of crisis. It is much more difficult to use mining shares for such purposes.

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