Gold Chart

Risks and Benefits of Gold

Risks of gold can be grouped into 1. risks arising from the physical ownership of gold (gold coins and bars), 2. risks at the gold exchange, 3. the volatility of gold, 4. political risks and 5. gold scams.

Risks of Gold

1. Physical Risks of Gold
2. Gold Exchange Risks
3. Volatility
4. Political
5. Gold Scams

1. Physical Risk of Gold

The first downside of gold investment is the physical risk. Buying gold bars and coins exposes the investor to the risk of loss and theft.

Costs are involved to mitigate this risk. The transport of gold needs to be insured, gold has to be kept in a personal safe at home, or, better, in the bank’s safety deposit box. Here, renting fees incur.

A bank vault is probably the safest place for storing gold. However, investors should not believe that the bank will store the precious metal for generations. HSBC customers had to face this. The bank asked end of 2009 its small retail customers to remove their gold from the bank’s New York vault. This resulted in an armada of armored cars, bringing gold out of New York.

Another advantage of a bank safety deposit box is that the gold is not immediately available, as it can be only accessed during bank hours. Another issue is the insurance limit: In Germany, for example, bank safety deposit boxes are insured only until US$ 28,000. With the current gold price, this corresponds to 20 gold coins (each 1 ounce), or 567 gram. How secure are safety deposit boxes? Well, this depends on the paranoia of the investor. In the first quarter of 2010, thieves removed in a bank in Paris the contents of around 100 safety boxes. A couple of month later, in French Bank, nearly 200 safety boxes were cracked open and its contents stolen.

Property insurance usually either has a limited cover for loss of physical gold, or does not cover it at all. In both places, additional coverage needs to be purchased.

Besides safety boxes and personal safes at home, some people bury their gold on their property (midnight gardening). Will this reduce the risk of physical gold? In some ways yes, as it reduces the likelihoods of theft. However, those people should make damn sure to not forget to dig out the gold when they move, or before they die. Also, if the gold is immediately needed, it’s probably not possible to secretly access it.

2. Exchange Risks of Gold Trading

Exchange risks refer to the exchanges where gold and futures are traded, and not to currency risks. The two major gold futures exchanges are the New York Mercantile Exchange (NYMEX) and the Tokyo Commodity Exchange (TOCOM).  Trading at these and all other exchanges is subject to their rules and regulations. The exchanges can on purpose or accidentally foster market outcomes by changing their trading rules.

What events could happen at an exchange?

First, Margin Requirement Change: A margin requirement states how much money needs to be available in the futures account to be able to speculate on future contracts. The higher the margin requirement, the more money is needed to control the same amount of the underlying asset. If the margin in the margin account is below the margin requirement, then the investor either has to increase the margin, or sell securities. Thus, rising the margin will in average result in more selling and as a consequence in price droppings.

In December 2009, COMEX raised the margin requirements for gold (and silver) contracts. It was speculated that this increase would result in a bearish future gold market for three to six months.

Second, Liquidation only: This rare event means that the exchange temporarily restricts buying, so that only selling can happen thus driving the prices down. COMEX restricted silver buying in 1980, when this metal reached an all-time high of US$ 50. Will the exchange also declare a “liquidation-only” policy on gold, which also trades for a record price?

Third, Halt trading: This event is the most extreme measure. Here, an exchange temporarily halts  the trading of a particular future contract.

3. Volatility of Gold

The price of gold, as of every traded asset, is subject to the ups and downs of the market. The rate of this precious metal can fluctuate fundamentally. The volatility of gold must be a concern to all short- and long-term investors. (See the 6-month gold chart. The pattern looks quite unpredictable, doesn’t it?)

6monthgold Risks and Benefits of Gold

Its perceived value is shaped by demand and supply. The factors are gold production by gold mines, central banks, investors and the industry (jewelry, electronic etc.).

However, thinking that it is possible to exactly calculate and predict the gold price is plainly wrong. There are many factors that influence the price, but cannot be predicted, such as the discovery of new gold deposits, natural disasters that destroy gold mines, the interplay of the international financial system, inflation, interest rates and alternative investments, and lastly the irrationality of investors.

In average, especially since the beginning of the 21th century, the gold price has been raising.  This is because of the increased demand in emerging market (predictable), China, India, Russia and other country’s decision to diversify their reserves towards gold (partly predictably) and the financial crisis which made gold a more attractive investment (unpredicted by most).

The 10-year upward trend of the gold price asks for caution: First, gold is now at an all-time high. Thus, investors who buy gold now do it when the price is as high as never before. Is this a wise move?

Second, history (look at the two decades after the 1970s) tells us that the gold price can fall, and stay down for extended periods. If someone had bought gold in 1979, that investor would have to wait for thirty years until the gold price had reached the same level, so that a sell would not result in a loss (not considering inflation  and opportunity costs).

Third, oil is in many respects similar to gold: it is a popular commodity among traders, both are finite resources, extraction is costly and difficult to replace. The recent history of the oil price should be a warning of the volatility risk of this commodity, and of all assets.

Oil stood in the beginning of 1999 at a low of US$ 19 per barrel. Nine years later, in July 2008 oil was at US$ 147 per barrel. Within one year the price fell to some US$ 34. This is an unprecedented drop of 77 per cent within just twelve month. Could this also happen to gold? How to know when the gold price has reached its peak?

The volatility of gold is a market risk. Another risk of this category is the liquidity risk. This occurs in thinly traded markets, where sellers have difficulties in finding willing buyers. Futures of not actively traded contracts might run into this risk. Shares of small stock mines might also face liquidity problems.

4. Political Risks of Gold Investing

The political risk of gold investing means that the government can change laws and regulations that may harm your investment in gold. These government interventions can happen in the country of the investor or in another country. Both would have an impact on the gold price, as supply and demand, or the invisible hand of the market will be disturbed.

First, prohibition of gold ownership: It is thinkable that the government prohibits the possession of gold and requires gold holders to sell their asset to the government at a fixed price.

In 1934 Franklin D. Roosevelt passed a law that made it illegal to possess gold. The only exception was gold for industrial and artistic purposes. The price was fixed at US$ 20.67 for which one ounce of gold had to be exchanged. The US congress passed this law to prevent private gold to become a competing currency. The possession of gold by private citizens with only legalized 39 years later in 1973 by President Gerald Ford.

Second, nationalization of gold mines: Politicians could also nationalize gold mines or heavily tax companies that produce and trade in this precious metal.

In 2005 Chavez, the Venezuelan president announced the confiscation of the property held by Crystallex, a Toronto-based gold-mining company. This resulted in a drop of its share price by 50 per cent in a single day. Besides that, the dictator levied taxes on many foreign countries or nationalized whole industries.

Third, fixed gold price: The government could first, limit and control gold trading by restricting the amount of gold to be sold or by determining a fixed price.

Before 1972 the gold price either directly (classical gold standard) or indirectly (Bretton Woods System) determined the value, and the exchange rates of the currencies of most Western Nations. Therefore, their governments determined a fixed gold price. During this time, the gold rate was not volatile which made trading and speculating in this precious metal a futile act. Even though currently the gold price follows the law of the market, future governments might reintroduce a fixed gold rate so that the national currency can be pegged to this metal. Or the government might decide that gold trades for a too high rate. The US Commodities Futures Commission already has the authority to dictate a trading halt for futures. This might be used on gold futures.

How to anticipate and circumvent these government risks? First, an investment in gold mines should occur only in stable countries, such as Canada and Australia (unless high risk investments are desired). Second, it might be wise to distribute personal gold reserves to several countries, in case of confiscation. Third, investors should always be well-informed about world news which can influence the gold price.

5. Gold Scams

A gold scam is either 1. downright fraud, 2. misrepresentation or 3. market manipulation. To be knowledgeable about gold scams is necessary to anticipate and avoid them.

First, Fraud: Buying scrap gold (old jewellery) for only half or less of the gold price can be considered as fraud. Typically, businessmen having this in mind announce their scrap gold sale in local radio stations and rent a hotel lobby on a Saturday morning for this purpose.

Another way of fraud is selling gold numismatic coins at prices which highly surpass the material and collector’s value. The victims are often old people who can easily be tricked into this business deal.

From time to time Nigeria emails arrive in the inbox. Here, a businessman with connections to Nigerian gold mine tries to sell gold by the kilo for prices that are far lower than the current gold rate. Of course, this was a legal business and gold export licenses did exist. The only catch, for the transaction it is necessary to fly to Nigeria. (It is up to the email recipient to decide whether this is a genuine business opportunity.)

There is also a (very) slim change that gold buyers receive inferior gold, referring to a lower value or fineness.

Second, Misrepresentation: Imagine, a bank sells gold which the buyer never physically receives, but which is stored in the bank’s vault. The bank further charges the gold owner storage fees. So fine so good. Let’s now assume the owner of the precious metal insists on seeing the gold. Now it is discovered that the bank never actually possessed the gold. How would one call the bank that asked for storage fees of something it never stored? Do you think this incident is highly hypothetical, or would happen only in dodgy countries?

Well, this allegedly happened at the bank Morgan Stanley.  In 2005 a class-action suit was filed against Morgan Stanley. The bank was accused of selling between 1986 and 2005 physical gold and other precious metal to clients who paid fees for storage at this bank. But allegedly Morgan Stanley either made no or a different investment on behalf of its clients. The result was that Morgan Stanley would pay US$ 4.4m to settle this class action suit. “While we deny the allegations, we settled the case to avoid the cost and distraction of continued litigation,” Morgan Stanley said in a statement. See a Reuter’s article about this case.

Third, Market Manipulation: The last gold scam is market manipulation as this action tries to distort the market equilibrium.

For example, in the beginning of 2007 there was an incident regarding naked short-selling among stocks of smaller mining companies.  Here, shares were massively sold to force the price of the shares down.

Also, governments could be labelled as market manipulators if the restrict the free trade of gold. Vietnam is such as case. In the beginning of 2011 it was reported that the government had plans to ban the trade of gold bars on the free market.

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