Throughout the 1980s and 1990s, gold was generally a poor investment. If you talked to most investors, it was rare to find someone who had any significant investments in gold.
While it is still not a common investment, a lot more people today recognize the importance of owning gold as part of a balanced portfolio and simply as a hedge against a declining currency.
It is also a lot easier today to hold gold and gold-related investments than ever before. You can buy gold stocks, gold exchange-traded funds (ETFs), mutual funds, and actual physical gold. And you can buy many of these things in a matter of seconds through an online brokerage account.
With that said, there are significant differences between investing in physical gold and investing in mining stocks. The two are somewhat correlated, but they serve very different purposes in an investment portfolio.
Mining Stocks
Like most investments, there are pros and cons to owning mining stocks.
Whether you are buying an individual stock or a group of stocks in a mutual fund or ETF, the concept is still the same: You are not buying gold; you are buying the company.
When you buy a company, you are buying its operations and its property, which might include gold. But you are also buying its expenses and liabilities.
As with any stock, there are a lot of variables you must consider. The company’s performance is dependent on good management and good decision making from the top to the bottom.
It can get even trickier with mining stocks because most mining companies have operations outside of the United States. Property rights are generally secure in places like the U.S. and Canada. There are certainly taxes to be paid, but the laws are at least somewhat predictable.
When you get into places such as South Africa or certain parts of South America, however, there is a bit more uncertainty. There is more risk in terms of government confiscation or arbitrary changes in the law.
You must also consider that mining companies are generally highly leveraged. If the company is not using the futures and options markets to hedge some risk, then it will be very sensitive to price movements in gold.
Consider a company that is extracting gold from the ground for $1,100 per ounce. When gold is $1,200 per ounce, it is profiting $100 per ounce. If the price of gold goes up to $1,300, that is less than a 10% increase in the price of gold, but the company just doubled its profits.
On the other side, if gold drops less than 10% to $1,100 per ounce, then the company is no longer profitable.
This is an extremely simplistic example, but it is a good illustration of how mining stocks are often highly leveraged and, therefore, highly volatile.
Overall, mining stocks are extremely volatile, as we have seen in the last 10 years. There were years where mining stocks were going up 40% or 50% per year. But in more recent years, many mining stocks have been going down 40% or 50% per year.
Mining stocks offer a lot of risk but also a lot of potential reward.
Physical Gold
Owning physical gold is far more stable. It certainly goes up and down in terms of currency prices, but the swings are less wild than with mining stocks.
When you own physical gold, you take away a lot of the variables that exist for mining stocks. You don’t have to worry about bad management, where the gold came from, or what some foreign government is going to do.
The main threat to your gold is a thief, which could include your own government. But even here, I believe the chances of a government confiscation are low, as the dollar no longer has a link to gold.
When you own gold, it is what it is. You can buy it and hold it for as long as you want. You also have the advantage of actually being able to possess it in your hands, unlike owning a stock. Of course, you can also buy gold certificates or ETFs, where someone else is storing your gold for you. Both are viable options.
Gold is a hedge against disaster, and it is a hedge against out-of-control governments and central banks. It protects you, at least somewhat, in a scenario of high price inflation or hyperinflation.
Volatility in the gold price is really a reflection of the volatility of currencies, as controlled by central banks. It is not so much the gold that is volatile as the currency in which it is priced.
Of course, when you own gold, it is not somebody else’s liability. It is not dependent on somebody making good on a promise or on customers or profits or management. It is simply a precious metal that has been in high demand for thousands of years and will likely stay that way for thousands more.
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Your Investment Portfolio
I believe everyone should hold about 20% to 25% of an investment portfolio in gold and gold-related investments — ones that reflect the price of gold, such as ETFs. This would not include mining stocks.
I am not against owning mining stocks, but it should be done on a speculative basis with money you can afford to lose.
Since mining stocks are far more volatile, they offer quicker profit opportunities, but they also offer the opportunity to lose money quickly. Therefore, you should limit your exposure to mining stocks. It is also something you should more actively trade, unlike physical gold, which you can hold long term.
Mining stocks have taken a beating over the last several years and are completely out of favor with most investors. That is also what makes these stocks an interesting speculation now. We probably have not hit bottom yet with mining stocks, but it is quite difficult to ever time the bottom in any market.
But every investor should have his core holdings of physical gold. When included as part of a well-diversified portfolio, gold will actually stabilize the portfolio and make it less volatile.
Gold is a vital component of a well-diversified portfolio, as it is a hedge against currency depreciation. Stocks in general will not always perform well in a high-inflation environment.
If and when there is a new bull market in metals, I expect gold to do well, and I expect mining stocks to shoot to the moon. You could easily see mining stock prices doubling in a matter of months. But you also will have to know when to take profits off the table and to not get greedy when the time comes.
If gold is ever in another major bubble like it was in 1980, then you will want to get out of mining stocks quickly but hold onto some of your physical gold investments.
Bottom line: Invest in physical gold for the long term, and speculate on mining stocks for quick profits.
Until next time,
Geoffrey Pike for Wealth Daily
