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All About INVESTING IN GOLD
THE EASY WAY TO GET STARTED
By JOHN JAGERSON, S. WADE HANSEN
The McGraw-Hill Companies, Inc.Copyright © 2011The McGraw-Hill Companies, Inc.
All rights reserved.
Gold Market Background
We decided to stay fairly high-level in this section of the book so that we could concentrate on practical applications and investing strategies in the gold market. However, there are still a few things you need to understand about how gold is traded, who owns most of it, and why investors are so interested in the metal before you step into the market. Some of what you will learn will be a surprise and may motivate you to do some research on your own. There are some great resources for that kind of research, but be careful. The way gold is traded and priced today is very different from what it was at any time in the past.
Gold is traded by official (government or quasi-governmental) traders as well as the private sector and individuals. The official sector is many times larger than its private counterpart, but this kind of overlap is not unusual. Bonds, real estate, and commodities also are subject to massive interference from the official sector. However, unlike some of those other assets, gold is remarkably liquid and changes can be made much more quickly. Sometimes those changes can have a very material impact on prices; this is one of many reasons gold investors are so interested in monitoring the participants in the official sector.
Official and private gold investors trade in a few different markets. At the highest level most bullion is traded on the London Bullion Market by official traders (central banks mostly) and the largest international banks, some of which are referred to as bullion banks. Daily trading volume on the London Bullion Market is regularly equivalent to more than an entire year's worth of gold production, and many of the traders in the market are highly leveraged; this helps explain why the gold market can be so volatile.
Most private investors actually invest in gold through physical bullion (bar hoarding), but this is a very bullish and illiquid position for small traders. As a rule we suggest using exchange-traded products such as futures, options, and ETFs before beginning to buy physical bullion. Exchange-listed products have more flexibility, which is important for traders who are focused on strict money management and the benefits of diversification. The London Metals Exchange leads the world in gold derivatives trading, with the New York and Chicago futures and options exchanges right behind it in total volume. Exchange-traded funds (ETFs) are traded on the stock exchanges and are becoming more popular in the private sector. We see no signs that this interest will slow in the near term. For very small traders or long-term investors we feel that gold ETFs are probably the best way to access the gold market. In this book we will explain how to evaluate and invest in gold ETFs and how to use options on gold ETFs as a way to reduce volatility or gain additional leverage.
Besides knowing where gold is traded and how it trades, you will learn three basic things in the background section of the book. First, gold acts like a currency, and official and private investors treat it like one; that means it trends very differently than do other assets. As a currency, gold is "stateless," but it is influenced very heavily by the largest central banks in North America and Western Europe. Second, it is an extremely liquid market, which makes it very flexible and efficient. Liquidity is a big advantage for small traders and investors because it increases flexibility and keeps costs low. Third, gold and politics can be difficult to separate; this can be a hot button topic for many investors and analysts. This situation can be frustrating because political issues are emotionally charged and traders have to be unemotional about their investments to be able to make good decisions.
WHAT GOLD ISN'T
There are a lot of myths about gold, and it can be difficult for new investors to tell the difference between what is real and what isn't. In many cases myths are perpetuated as a way to create buying demand for gold investments, especially by gold bullion dealers, and we think it is important to consider the source when evaluating whether a particular statement about gold is true. The report you downloaded on the Internet or picked up at an investing trade show may be nothing more than a marketing piece for a bullion dealer.
The best myths are actually a mix of truth and speculation that lead to a conclusion that is either not true or impossible to prove. Others are entertaining examples of coincidences that have no relevance to today's market. Our challenge to you is to remain skeptical and do your own research to make sure you understand what you are getting into before you make a big financial decision. The following is a short list of our corrections to favorite myths that you should consider before jumping into the market. We start with those that are more of a misconception than a myth and end with those that are more troubling.
Gold Is Very Different from Stocks and Bonds
Gold is not like stocks and bonds, and it is different in some very important ways that should not be misunderstood. Gold often moves contrary to other major investment asset classes, but it can also unexpectedly become correlated with both stocks and bonds. For example, through the third quarter of 2010 stocks, bonds, and gold all began trending in the same direction. In fact, through most of the nascent economic recovery of 2009–2010 stocks, bonds, and gold moved the same way. This wasn't a problem for traders who happened to be long all three asset classes, but it raises questions about what would make them act like that and whether it represents a risk for gold investors.
Bonds are created to return value to investors. Debt pays interest and is designed to provide a return that is proportional to the risk the lender or investor is taking; therefore, the underlying purpose of a bond is to provide a return. Sounds obvious, we know, but this is a key differentiator between bonds and gold. Although it is technically possible to earn interest on certain gold deposits, gold does not return an income stream the way bonds do and probably never will. That means that gold will compete for investment capital with bonds when yields are high. That competition works against gold investors when yields are high and the economy is growing.
Stocks are actually quite similar to bonds in the sense that a share's price is equal to the discounted present value of its estimated future stream of payments (dividends). A company issues stock and proposes to investors willing to take a risk that the company has the ability to grow top-line revenue and bottom-line profits. Investors buy a stock because they believe that those future payments will return profits that are worth the risk they are taking. Because gold doesn't offer a meaningful income stream and isn't designed to grow in value, its trends are different from those of stocks. As you can imagine, because gold must compete for investment capital with stocks, it doesn't always do well in a bull market.
What you need to remember is that gold is not an investment that has been intentionally designed to go up or to create income for its investors. Over the very long term the purchasing power (value) of gold is "mean reverting," which means that it remains relatively flat. This is not a bad thing. Because of its ability to preserve value, gold is considered a good long-term store of value, and that is why it is such a good asset for account diversification. A store of value or safe-haven investment such as gold tends to perform poorly in an economic environment of high interest rates, strong economic growth, and relatively low inflation. The middle to late 1980s and the late 1990s were
Excerpted from All About INVESTING IN GOLD by JOHN JAGERSON. Copyright © 2011 by The McGraw-Hill Companies, Inc.. Excerpted by permission of The McGraw-Hill Companies, Inc..
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