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How To Invest In Gold And Silver

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by Gavin in Blog
June 22, 2020 3 comments

Today we are looking at how to invest in gold and silver.

Few things on Earth capture people’s hearts and minds the way gold and silver does.

Since ancient times it has served as a display of wealth, status, and power, used in jewelry, ornaments, and lavish decorations.

It has also played an important role in the transfer of goods and services, with the precious metals used by many countries and kingdoms as a form of currency and store hold of wealth.

The metals have played such a central role in history that they have been at the center of the rise and fall of many empires, spurring nations onto war and battle, colonization, and invasions.

Despite this, many people are surprised to learn that today it still plays an incredibly central role in the wealth of nations.

Central banks and governments around the word hold vast sums of gold in underground vaults and it is upon this precious metal that the entire global financial system rests.

Without gold, the ability for countries to trade with one another would be impaired and we perhaps would not have enjoyed the benefits of an increasingly globalized world.

Despite the importance of these precious metals, most investors do not have them as part of their portfolio.

There are a number of benefits to doing so, most notably in specific economic climates.

However, access to these metals can sometimes appear to be prohibitive due to the cost and complexities of acquisition and storage.

Fortunately, a number of innovations in the marketplace mean that it has never been easier to access gold and silver and include it as part of your portfolio.

This article will explain how you too can invest in gold and silver, starting with an explanation of their history and importance to give you context, the role they play in modern finance and why that matters, how they can boost your portfolio performance, how to best structure your portfolio, and finally, the different ways to add them to your portfolio.

Contents

A Brief History Of Gold And Silver

Gold and Silver have a long and rich history with human beings, which means that it has left a lasting impression on our perceptions of wealth and status.

This history is so powerful, that it influences how we use gold and silver today not just in our personal lives, but also in the way countries interact with one another.

It is for this reason that investors should understand the basic history of gold and silver so that they can appreciate why these precious metals play the role that they do in modern finance.

For thousands of years, human beings have coveted both gold and silver.

In fact, archaeological discoveries in Bulgaria find that humans used gold as treasure as far back as 4000 BC.

A few hundred years later, around 3600 BC, the ancient Egyptian goldsmiths learned how to melt gold ores and by 3100 BC they even developed their own exchange rate with silver, whereby one part of gold was equivalent in value to 2.5 parts of silver.

The Mask of Tutankhamun
Source: Wikipedia

Silver exploded in popularity in 3000 BC when the peoples of modern-day Turkey discovered how to mine it and soon it saw widespread use as items of jewelry, ornaments, and even as eating utensils.

Around 600 BC, gold and silver were elevated to the purposes of a store of value used for trade – that is to say, it was used as money.

It wasn’t until 1973, over 2,500 years later, that the United States would come off the gold standard, forever decoupling gold from money.

For thousands of years, gold and silver were used as money – and this is reflected in the stories we tell from generation to generation, and the value we still give these precious metals today.

This long and rich history means that despite the US and other countries being off the gold standard, gold still plays a vital role in US and global finance.

The Role Of Gold And Silver In Finance Today

As more and more countries adopted gold and silver as their system of money, it meant that trading between kingdoms and countries became easier.

Over time this meant that countries that were able to amass the most gold and silver, whether through mining, trade, or by taking it after a war, would see their wealth and status improve.

For example, when the Spanish explorers of the 15th and 16th centuries discovered Central and South America, they met many different indigenous tribes with different cultures.

However, one common thread amongst the different tribes and the Spaniards was a common love of gold and silver, with all groups using it for display, decoration, and wealth.

The Spaniards ended up taking all the gold and silver from these areas, taking 154 tonnes of gold and a staggering 7,400 tonnes of silver.

So successful was the pillaging of the Americas that between the early 15th and mid 16th centuries, Spain was able to set the world’s reserve currency.

This occurred because by having so much gold and silver (and therefore money), any claims on money were a lot safer for Spanish coin compared to other currencies as these were more likely to be honored.

15th century Spanish coins
Source: Foxnews.com

Over time an increasing amount of trade was made in Spanish coin and by virtue of its strength and influence around the world, it became the world’s reserve currency.

This dynamic worked in similar ways throughout history to make other currencies such as the British Pound and the United States Dollar into reserve currencies.

Most people are familiar with the United States holding the title of the world’s reserve currency, but what many people don’t know is that this has been true for only the last 80 years.

Before World War 2, the British Pound was the world’s reserve currency.

However, as World War 2 raged on the British economy, like many of its Allies, was getting ravaged by the fighting and the huge burden of manufacturing weapons and defenses.

The United States supplied the Allies with machinery and weaponry and in exchange, it received gold.

It made more sense for the United States to be paid in gold rather than currency as there was no guarantee the British pound or other Allied currencies would exist after the war.

In this way, the United States amassed the largest store of gold in the world, such that at the end of World War 2, coupled with the US economy being the strongest in the world, the US dollar became the world’s reserve currency.

Today almost all countries and central banks store gold  as part of their reserves, despite gold no longer being tied to the dollar.

Reserve Bank Gold Vault
Source: Businessinsider.com

As for silver, it fell out of favor in the 1870s when its value decoupled from gold, requiring governments to choose one as a reserve asset.

In total, current estimates are that global reserve banks hold a combined total of 34,000 tonnes of gold.

While each central bank has its own reason for holding gold, in general, they hold it for its ability to be used whenever there is a crisis, to serve as an emergency reserve, and to serve as a form of insurance.

For example, should there be some form of economic collapse that leads to the downfall of a nation’s currency, they can draw upon their gold reserves to buy foreign currency or trade directly with other nations to get the goods they need.

The other key reason why gold is held is that since there is a fixed supply that is mined into existence, it means that there isn’t the same default risk you might have with government-issued currency.

Its universality means that governments can also use it as collateral when dealing with one another.

As an asset central to modern finance and with many new products on the market for acquiring and holding gold and silver, it is worth every investor considering how it can help their portfolio.

How Gold And Silver Can Help Your Portfolio

For individuals, gold serves similar purposes to central banks, in that it can also be used as a form of emergency reserve and as an asset with no default risk.

For investors, it also serves an additional role outside of doomsday economic scenarios, most notably as a response to currency devaluations.

As most global currencies are no longer tied to a gold standard, it means they are free to print fiat money as and when required.

When a central bank prints money, it makes existing money worth less – that is to say, the currency is devalued.

It is for this reason that many investors use gold as a hedge against currency devaluation, as the price of these metals tend to rise during devaluations owing to the fixed supply of gold and the value placed on it by central banks.

Silver, while no longer playing a central role in modern financial institutions, still maintains some of its reputation as a storage of wealth.

For investors, most important is the use of silver in modern industry, where it is used across a number of sectors owing to it having the highest conductivity of electricity and heat for any element.

Source: zpowerbattery.com

For example, silver is used in many of the world’s most advanced and important industries such as batteries, medicine, solar energy, semiconductors, water purification, and touch screens.

This makes having both silver and gold in a portfolio as an important consideration.

How To Structure Your Portfolio With Gold And Silver

Now that we’ve covered the history and importance of gold and silver and how they can help your portfolio, we’ll now delve into some of the considerations for how you might wish to structure your portfolio.

There are two main ways to structure your portfolio to take advantage of gold and silver:

1. As a speculative play
2. As a hedge

While there’s absolutely no reason why you can’t do both approaches when structuring your portfolio, it is important that you are absolutely clear on which approach you are using and why.

This is because they will require different time horizons, different trade and portfolio management strategies, and dictate which type of financial asset you might use to get exposure to these metals.

Gold And Silver As A Speculative Play

The first approach to using gold and silver is as a speculative play.

In this approach we are seeking to capitalize on short-term moves in the price of these metals, betting on price increases and decreases.

The mindset for this approach is that we are seeking opportunities where the metals have, or will diverge from their fair value and that we want to be in and out of the trade as soon as possible.

The divergence from fair value price will be driven by real or perceived supply and demand constraints.

On the demand side, these metals are in constant demand by central banks, investors, industry, and consumers.

Gold is supplied to these groups predominately through mining, with trading/transfers the next most common way.

In a properly functioning market, these demand and supply forces are balanced, however, there are many ways in which they can be disrupted.

Examples include:

• A central bank wishes to purchase more gold to bolster its reserves ahead of perceived future economic and security risks.
• An accident forces the closure of a large gold or silver miner.
• An existing gold/silver vein is completely used up and new sites are limited or non-existent.
• A new, in-demand technology is developed that requires the use of silver.
• Changing consumer appetites for gold and silver (e.g. India has seen a ramp-up in domestic gold consumption as the population has become wealthier).

Since gold must be mined, there are limitations to the pace at which miners can ramp up and ramp down production – new mines cannot be built instantly and existing mines will have capacity constraints.

It is for this reason that there have been many times in history that a surge in demand or a drop in supply has caused volatile swings in the price of gold and silver.

Gold prices over the past 100 years
Source: macrotrends.net

This is not only caused by ‘real’ factors, but it can also be caused by emotion and perception.

For example, gold is seen as a safe asset in times of stock market and economic turbulence.

When stock markets rise to bubble levels, some investors will begin adding gold and silver to their portfolios.

This provides them with a relatively safe and somewhat liquid asset that they can sell in the event that they need to get additional cash or cover margin requirements.

This causes a run-up in the price of gold and silver in the lead-up to a stock market crash.

However, it is worth bearing in mind that while not intuitive, the price of gold and silver tends to drop during market crashes.

This is predominately caused by the fact that gold and silver are priced in US dollars and in times of economic stress, the demand for US dollars increases, thus lowering the price of precious metals.

Managing the trade

When speculating with gold and silver, you’re looking at understanding two key criteria – what is the triggering event to kick off the imbalance and how long to remain in the trade.

For example, you might be seeking to profit from stock market turmoil.

You start by working out the first of the two criteria, being the triggering event that will kick off the imbalance.

You might start by observing the general pattern of what happens to gold and silver prices during periods of stock market stress.

During this process, you discover that prices rise in the lead up to bubbles bursting and subsequently fall as the market crashes.

Next, you might determine a filter for what constitutes a bubble, to help you spot them in advance – this could be from fundamental analysis, technical analysis, or a combination of the two.

You might find that when the market rises over one standard deviation above its’ long-term Price to Earnings ratio, this indicates stocks are overvalued and at risk of a price crash.

So when this happens, you will start to accumulate gold.

The second of the two key criteria is to determine how long you will remain in the trade.

For this, you will have to use fundamental and technical analysis again to determine when the supply and demand equilibrium will be resolved.

Since you’re looking at market turmoil, you might see that bear markets occur when stock market prices fall by at least 20%, so you use that as your exit criteria.

Advanced investors may also consider using the exit criteria as an entry point for the opposite trade – going short, which is the process of betting on the price falling by selling more gold and silver than you actually own, with the hopes of buying it back for a cheaper price later on.

You can apply this same pattern of analysis to different scenarios, such as a miner closing down, increased central bank demand in times of economic stress, observing changes in consumption patterns, etc.

In all cases, the trades are very rule-based – you will have reasons (fundamental and technical) for a supply/demand imbalance to be triggered (the event) and you will have reasons for how long you will hold the trade.

As you’ll see from the hedging approach in the next section which is much more straightforward, speculation is quite an involved and analytical process – but the rewards are much higher.

Which asset types to use

To maximize your returns from speculative trades, you want to ensure you can get in and out of the trade quickly.

That’s why buying physical gold and silver, despite the allure of holding it in your hand, is not a recommended asset for this approach.

There are four main asset types you may want to consider for speculation:

Shares

Shares allow you to get exposure to gold and silver via companies that mine them.

Therefore, this asset type is particularly suited for speculative trades that rely on a shortage of physical metal, such as a rival mine closing or changing long-term consumer trends.

Prominent gold and silver miners listed on in US markets include:

Newmont Goldcorp (NEM), the largest gold miner in terms of market capitalization, with mines across America and Australia and substantial operations involving silver.

Barrick Gold (ABX) is one of the largest gold miners in the world and is suited to a pure gold play given that 90% of its revenue is driven by gold mining.

Agnico Eagle Mines (AEM) has a diversified portfolio of mining operations, including both silver and gold, and a long history of paying steady dividends.

Kirkland Lage Gold (KL) has assets based in Canada and Australia and is one of the fastest-growing gold miners.

Hecla Mining (HL) is the largest and oldest silver focused producer in the US and it is also developing its gold production capabilities.

Pan American Silver (PAAS) has several silver mines across a number of North and South American countries.

Silvercorp Metals (SVM) has the majority of its operations located in China, where it specializes in silver mining where there are underdeveloped mines with a high upside.

Futures

Futures provide gold and silver traders with a number of features that make them highly suited to speculative trading.

Source: globalaccountancyinstitute.com

The first is that they use leverage which means that a trader can control a larger amount of gold and silver for a lot less capital than they would if they were buying and selling physical metals.

For example, one gold futures contract is equal to a standard brick of gold at 100 troy ounces.

If the current price of gold is $1700 an ounce, the value of gold the contract would control would be $170,000.

However, since futures operate on margin, you would only need approximately $11,333 to control that contract.

That means for $11,333 you get to control and profit from, the moves of $170,000 worth of gold.

Give the value of one futures contract, trading gold futures is not feasible for most retail traders.

The other advantage of using futures is that you can just as easily enter a short position as a long position, giving you the opportunity to profit from both price rises and price falls.

There are two exchanges where gold and silver futures are traded.

COMEX offers a 100-troy-ounce gold contract and a 5,000-ounce silver contract.

eCBOT offers the same contracts as COMEX, with the addition of mini contracts – a 33.2 troy-ounce gold contract and a 1,000-ounce silver contract.

ETFs

ETFs are an increasingly popular way for people to invest as they are exchange-traded, meaning you can buy and sell them in exactly the same way you do with regular stocks.

The added bonus is that ETFs can also provide diversification, in that rather than forcing you to buy stock in a single company, an ETF could track multiple companies or even stock of the precious metal themselves.

Prominent examples include:

iShares MSCI Global Gold Miners ETF (RING) which tracks a minimum of 30 gold miners across developed and emerging markets.

Global X Silver Miners ETF (SIL) which tracks global companies that are involved in silver mining.

ETFMG Prime Junior Silver Miners ETF (SILJ) is focused on small-cap silver miners and explorers.

VanEck Vectors Junior Gold Miners ETF (GDXJ), despite the name, tracks small-cap companies that generate revenues from both gold and silver mining and production.

VanEck Vectors Gold Miners ETF (GDX) tracks mostly large miners of gold, and some small amount of silver miners as well.

Options

Options provide a fourth and final way of speculating on gold and silver price moves.
Options have the advantage of  providing income  (called the premium) and capital gains from directional bets.

Source: tradebrains.com

The other advantage is that they are a derivative, meaning that an options contract is based on an underlying security.

Options traders have flexibility in choosing which asset will be the underlying security, so it is possible to buy and sell options based on any of the individual stocks, ETFs, and futures contracts mentioned previously.

Like futures, options also provide the means of going both long and short, as well as to use margin.

The main difference is that unlike a futures contract that controls the underlying asset, an options contract gives the holder the right, but not the obligation, to buy a set number of the underlying asset at a given date.

You can either exercise your right or allow the option to expire worthless, which provides traders with a lot of flexibility to speculate on price moves in a manner and timeline that suits them.

Regardless of which of the four assets you choose, all have the liquidity and flexibility to allow traders to speculate on the price moves of gold and silver.

Speculation is not the only use of gold and silver in a portfolio so we will now turn our attention to the second use – that of a hedge.

Gold And Silver As A Hedge

A hedge is a risk management strategy whereby an investor is looking to protect some or all of their portfolio from downside risk.

For example, if you were buying stocks on the UK stock exchange you would have to pay in Pounds.

Any stocks you buy would therefore be priced in Pounds as well.

So not only are you exposed to the movements of the stock, but you are also exposed to the movement in the Pound relative to the USD.

To avoid this, a hedge can be created to offset this risk.

Gold and silver can be used as a hedge as well – specifically, against currency devaluation.

Currency devaluation generally occurs under two broad categories, the first being inflation and the second being monetary policy involving money printing and quantitative easing.

As alluded to earlier, gold and silver act as a hedge as it is an ancient form of money and there is a limited amount that can only be produced by mining.

This means that as money becomes worth less over time via inflation or printing/quantitative easing, you need to spend more money to buy the same amount of gold and silver – hence pushing up the price of gold and silver.

How To Manage The Trade

The best way of managing the trade is via an ‘all-weather’ approach.

The all-weather approach is a style of portfolio management made famous by Ray Dalio of Bridgewater Associates, one of the largest private hedge funds in the world.

The general principle of the all-weather approach is that you maintain a portfolio of diversified investments that perform well regardless of how the economy is performing.

The way this works is that the portfolio is made up of different asset types that perform well in different economic conditions.

For example, stocks perform well as an economy grows, but as economic growth falls, long-term government bonds perform better.

Source: which-50.com

Likewise, if inflation is low, developed equities perform well while rising inflation boosts commodities and gold.

By keeping a mixture of all these assets in your portfolio, you effectively have some assets that will always perform better than others in certain economic conditions and you don’t have to worry about trying to time the market.

Gold is best used as a hedge against inflation, while silver should form part of a commodities basket, which together, also hedges against inflation.

In terms of allocation, Ray Dalio recommends between 5-10% of your portfolio be in gold, depending on where we are at in the economic cycle (i.e. towards the end of the big debt cycles when money is likely to be printed to stave off a recession).

Whereas commodities (which include silver) should be around 7.5% of your portfolio.

Since this is an ongoing hedge against inflation, you’re not trying to time the market so you will always maintain a position in both gold and silver.

The way the trade is managed is that you will regularly review your portfolio mix and buy or sell gold and silver such that you always maintain your desired asset allocation.

Say you want your gold to be at 5% of your portfolio, and commodities at 7.5%.

If gold goes up as a result of inflation, the increased price will make it a higher proportion of your overall portfolio assets (since other assets will suffer in a high inflation environment).

When your next portfolio review arrives, you rebalance your portfolio by selling some of your gold assets so that the total value of gold in your portfolio returns back to 5%.

While there is no set rule for how often to rebalance your portfolio, for most investors either monthly or quarterly is sufficient.

Which asset types to use

Since the aim of using gold and silver as an inflation hedge is to maintain a constant allocation in your portfolio, some financial assets are better suited than others.

Shares

Using shares are not as effective as other financial assets when attempting to use gold and silver as a hedge.

The reason being is that you would be buying shares of gold and silver miners rather than physical gold and silver as well.

This means that you are adding risk to your hedging position because you will also suffer price moves in the company value as a result of the impacts of a high inflation environment on their company operations.

By choosing other financial assets you can avoid this added complication and maintain a more ‘pure’ hedge.

Futures

Like shares, futures are not as effective as other financial assets when using gold and silver hedge.

Since futures are a contract, it means they have an expiry date which will require you to roll over and buy and sell them regularly to maintain your hedge.

This presents you with two negative impacts.

The first is that because futures are bound by a set contract end date, speculators try to make short term bets using futures which creates excessive volatility in price, increasing the number of times you will need to rebalance your portfolio.

The second issue is that increased rebalancing as a result of volatility and contract rollovers means that your costs in maintaining this hedge go up, eating away at your profits.

ETFs

ETFs that are physically backed by gold and silver provide the optimal financial asset for hedging.

The reason being is that they are highly liquid, making portfolio rebalancing simple, they track the spot price of gold itself and are not a derivative.

Source: wsj.com

Generally speaking, these ETFs will track gold and silver that is physically stored at one or more locations around the world, with the most popular being London, Switzerland, and the United States.

Prominent examples include:

• SPDR Gold Trust (GLD) is one of the largest gold ETFs in the world with all underlying assets consisting of gold bullion stored in secure vaults.

• iShares Gold Trust (IAU) smaller than SPDR Gold Trust but similar in nature, iShares Gold Trust holds gold bullion in secure vaults and boasts a smaller expense ratio.

• Aberdeen Standard Physical Gold Shares ETF (SGOL) boasts Switzerland as its storage for its’ gold, offering investors an alternative location for protecting their assets.

• iShares Silver Trust (SLV) is the largest silver ETF, with the physical metal stored in vaults in London.

• Aberdeen Standard Physical Silver Shares (SIVR) also stores silver in London vaults.

Options

Like futures, options are also sub-optimal for a long-term hedge as they also come with a contractual end date (called the expiration date).

This means you will need to continually buy, sell and exercise options as they reach their contract end date, pushing up your holding costs, and also contend with short-term

Physical

The final way to invest in gold and silver is to buy the physical bars themselves.

Source: fxempire.com

This is not advisable as it requires effective storage to protect them and it is illiquid.

Should you wish to sell, you may not be able to sell the exact amount you’d like (as the metal is in bars, coins, or similar fixed pieces) and not everyone will be willing to buy physical metal.

It is best to stick with ETFs as the simplest, most liquid, and most cost-effective way to be exposed to gold and silver.

Conclusion

Gold and silver sits at the center of human history as a form of currency, store of wealth and as a decoration of valuable artifacts and jewelry.

Around 600 BC, gold and silver started to be used as a currency and it would remain so for almost 2,600 years until countries began the era of fiat money by delinking paper money from precious metals.

So important has been the contribution of gold and silver to human history, that despite being no longer linked to paper money, it is still kept by all the central banks around the world as a protection during economic emergencies and as collateral.

For investors, gold and silver are primarily used in one of two ways.

The first, is as a speculative asset, driven by supply and demand in many manufacturing processes (silver) and by investor sentiment (market bubbles).

The second use is as a hedge, to protect investors against inflation.

Thanks to financial engineering and advances in derivates, investors have access to a wide range of asset classes they can call upon to trade with to get exposure to both gold and silver.

For short-term speculation, options and futures present the best two asset classes owing to the ease by which investors can go both long and short, liquidity and leverage.

For hedging, ETFs that track physical gold and silver in vaults provide the best blend of liquidity and exposure.

If using a hedging strategy, investors should aim to maintain a steady allocation of gold and silver as part of an ‘all-weather’ approach and aim to rebalance the portfolio at least quarterly, if not monthly.

Despite the rich and long history of these precious metals, few investors capitalize on the unique benefits it provides to protect against inflation and currency devaluation, not realizing this is easily achieved using a host of accessible modern financial assets.

Trade safe!

Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.

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3 Comments
  1. Steven says:

    Great informative read!
    You haven’t removed the “Reviewed Up To Here” text comment. 🙂

  2. Peter says:

    Excellent article as usual, thank you Gav!

    1. Gavin says:

      You’re welcome. Thanks for the feedback.

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