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Not all so-called gold investments glitter.

Paper substitutes for gold, and gold investments offering leverage to the price of gold are not always what they appear to be, nor do they always live up to their positive billing. Quite often they introduce a degree of risk not present through ownership of real gold. In nearly every case they put the investor in the very position of risk he or she wanted to avoid in the first place.

Because numerous gold-related investments exist in the gold industry and financial sector, a novice investor may be confused and distracted by them, thereby failing to attain meaningful portfolio diversification.

investment riskAt the risk of stating the obvious, only the possession of the physical metal truly delivers the benefits of gold ownership.

Risk in these several gold derivative instruments is present in various fundamental factors which are often beyond the grasp for analysis by investors outside of the market-making institutions (and often befuddling even those within.)

Positioning yourself in metal offers not only portfolio insurance par excellence, but also offers a pure investment play -- giving positive exposure to gold's physical market fundamentals in which annual gold demand persistently outpaces new annual supply from mining. As discussed later, it is through unsustainable practices of bullion banking -- via the inflationary redistribution of existing gold holdings along with a creation of derivative "supply" -- that annual gold demand is met. That is, it is met largely by superficial appearances.

The long and colorful history of our banking systems and their strides toward efficient application of assets and deposits assures investors that such a day will arrive when the intervening paper-based gold contracts and account statements will fail to satisfy investor confidence as suitable gold substitutes, thus bringing the market's attention (and value) on physical gold to the fore -- that is, for any investor that actually has it. Further, in the event of a concurrent crisis in the domestic currency or and environment of cascading counterparty default, only gold metal (which has no counterparty or contingent liability) will preserve or even gain inherent value while other financial instruments may be deeply discounted in the global marketplace.

 

Gold Stocks (Gold Mining Shares)

Owning shares in a gold mining company is a substitute for owning gold in exactly the same way that owning shares of General Motors Corp is a substitute for owning a car or truck. That is to say, it isn't!

Investing in a gold mining company is similar to any other standard corporate share investment. Overlooked by many novice investors, the market value of mining shares on the stock exchange depends not only on the underlying movement of underlying gold prices to effect company profitability, but more importantly on the overall performance of the company itself which is subjected to numerous risks. These risks include

sovereign risk -- risks associated with the national government that has jurisdiction over the mine. In the interests of socio-political expediency any mine may be suddenly nationalized or quite simply taxed beyond any expectations for shareholder profits. There are also risks that environmental laws may be changed which limit mining operations or require profits to be set aside as provisions for costly measures of post-mining reclamation.

natural hazards -- entirely unpredictable earthquakes, landslides and flooding may cause costly and time-consuming damage or inaccessibility to the mine pit or shaft, and also cause damage to the developed infrastructure and equipment that supports the mining operations.

operational hazards -- the activity of mining can include accidents, collapses, and failures which, like natural hazards, can cause costly shutdowns or delays.

corporate and management risk -- as with any other corporate scandal, investment loss can be incurred through managerial malfeasance and bankruptcy. More innocently, bad or unfortunate decisions on operational details including expansions, financing, mergers, and management of the hedge book may limit any chance for profits that a shareholder may see in the form of dividends or capital appreciation of the stock regardless of the price of gold. Standing as a lesson to all, in 1999 a soaring gold price brought with it the bankruptcy and near collapse of several gold mining companies who were revealed to be adversely hedged to rising gold prices.

employee risk -- a worker strike or demand for pay raises may limit production and per ounce profitability, respectively.

mine depletion -- this is the most insidious and unavoidable of all risks in the life of a company's mining operation. Most properly, it should not be called a "risk" because, in fact, it is a certainty. Each day that a company extracts material from its ore body of minable gold resources brings that mine one day closer to exhaustion and closure. In efforts to extend the life of the company and thus preserve their jobs, management can be expected to divert mining profits (if any) into exploration or acquisition expenses. Mining is thus almost always a business that operates only at the very margin of profitability -- both by borrowing money (though loans or issue of additional shares) and by spending pre-tax profits to finance the exploration for and subsequent development of a new minable ore body to extend the lifespan of the corporation.

 

Gold Pools, Unallocated Statement Accounts

Like a dollar deposit account (checking or savings) held at a regular bank, these gold accounts may earn interest as an inducement to the depositor, or else these "holding" accounts may be offered to gold depositors without the usual storage fees that are normally charged for use of the more ownership-secure segregated storage facilities of allocated accounts.

These deposits of gold "on account" within an institution may flow nominally and also physically among the bullion banking system. Thus, these gold deposits are among the primary sources of ready gold that may be issued by commercial bullion banks for bridging the annual gap between newly-mined supply and total demand. This operation walks about with exposure to banking's classic Achilles' heel -- borrowing short term resources while lending them out at longer terms. You, along with all other depositors in the institution, will receive periodic account statements for the size of your claim, but there is no assurance that your gold may be available for withdrawal (or even transfer to an allocated account) in the event of depositor demand being heavier than normally anticipated by the banking institution, such as at times of financial crisis -- just when you'd likely need your gold most!

 

Gold Futures Contracts

These instruments are typically billed by commodities brokers as firm commitments to make or take delivery of a set amount of gold (100 oz per contract on the New York commodities exchange) at a set future date and price. These contracts are promoted and held as equivalent alternatives to possessing gold under the notion that the differentials in "future price" from current spot delivery price of gold reflect the interest cost of holding gold as well as insurance and storage fees. The stretch is that these contracts are as good as -- if not better than -- gold itself.

Because these contracts are easily standardized and marketable on an exchange, through the New York Comex these 100 ounce gold contracts have become popular vehicle for use in commercial price hedging and investor speculation in which physical delivery is more theoretical than actual.

As a result, although commodity brokers suggest that an investor may leverage his funds through payment of a small margin (currently $1,350 for each nominal 100 oz contract) thereby "controlling gold" (if not actually owning it) through their open position in futures contracts.

In the industry jargon, those who enter contract positions as "gold buyers" are known as longs, while those who enter positions as "gold sellers" are known as shorts. For every long position there is a short, and it is the making of a market between these quantities of "buyers" and "sellers" at any given price that passes for price discovery for gold in the American market. Spot prices for immediate delivery are mathematically calculated by adjusting the contract prices for the interest rates on cash and metal between the present time and the active futures expiry.

Gold investors acquire their metal from physical gold brokerages and dealers, while commercial operations generally contract for delivery directly through a refinery. In practice, therefore, a futures contract does not control gold any more than it represents a "firm commitment to make or take delivery" which in aggregate of its cash-minded speculating and price-hedging market participants it certainly does not. More properly, it may rather be said that these instruments represent a firm commitment to an entry price -- to pay or receive the difference in contract price movements experienced upon exit (through seeking an offsetting long or short position) at or before contract expiration.

The marketing appeal is that price movements in your favor represent real cash gains multiplied by 100 (for each nominal ounce in the contract.) However, historically the institutional players have typically held the upper hand with short positions, washing out the longs into making additional offsetting sales under pressure of margin calls on temporary downward price swings. Because these contracts expire, a long investor does not actually have the benefits of time, and may actually dither away thousands in margin payments without ever having an ounce of real gold to show for his expense.

In such seemingly happy circumstances of a rapidly rising price of gold for those with long positions, history has a keen way of showing how markets may tend to get disorderly to the upside, leading to rules changes in the interest of "market stabilization." These rules changes may adversely affect your potential winnings with long positions as they did with the Hunt brothers on the Comex exchange in 1980. Position limits were put into place and accompanied by other new rules that said speculator positions could be liquidated only. Naturally, the price of contracts plummeted in this enforced absence of buyers, and the resulting margin calls on position losses nearly bankrupted some very wealth players. Investor/gamble beware when the house has the ability to make the rules as the game is played!

 

Gold Options

On the New York Comex exchange these derivative instruments give the holder the right but not the obligation to be a buyer (a call option) or seller (a put option) of gold futures contracts at a predetermined strike price any time prior to their expiration date. For this right -- to enter the futures markets at a known price -- the option buyer pays a premium, the cost (or price) of the option. The option instrument itself may be sold at any time to realize a profit or loss on its changing market value as the underlying futures contracts move farther from or closer to the strike price. If the option is exercised prior to expiry, the option holder must pay the required margin to take his position in the underlying futures contracts.

gold investment risks

Note that none of these gold-related instruments offer the solid benefits of gold ownership for full diversification against such things as counterparty risk. Physical possession of gold -- the metal itself -- offers the best stabilizing force available for inclusion in most portfolios.


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