Options for Investing in Gold and Silver

Thinking Of Buying Gold Or Silver?  Overcome The Psychological Fear And Review Your Choices.

It has become clear to me that a lot more people have done their research and come to the conclusion that they should own some gold and/or silver as part of their total assets.

But, once you have come to that decision, then you have to choose the appropriate vehicle(s) to get into the precious metals markets.

In the past few months I have come to appreciate, much more than I ever have, that this second decision is far more intimidating to people than simply realizing that owning gold and silver is right for them.  There are so many options that I have seen a number of people who end up doing nothing.  Alternatively, I have also seen people who were steered in directions that did not suit their reasons for wanting to own precious metals.

Perhaps even more intimidating is the psychological impact of making a decision to step outside one’s past behavior pattern.  The ownership of gold and silver can be considered as a form of insurance against future calamities that may affect the value of the US dollar and paper assets such as stocks and bonds.  The mere idea of owning precious metals means that the investor is considering the possibility that the dollar may not be rock solid and that the stock and bond markets might fall or perhaps be inflated so much as to be worthless.

In other words, choosing to own gold and silver may actually feel like “betraying the American way of life.”

The simple fact is that the financially sound America of decades past no longer exists.  Every day, the politicians are pushing the country closer to the precipice of disaster.  The nature of the political system rewards politicians who spend extravagantly and punishes those who advocate responsible financial practices.

No matter what the politicians say, they will not protect the wealth of the average American.  In fact, their collective actions will (openly or stealthily) steal the wealth of middle class Americans.  That means that it is up to each individual to take steps to protect their financial health.  Owning gold and silver has historically been one of the best safe havens for part of one’s wealth.

For instance, when Indonesia’s currency was devastated as part of the Far East financial turmoil in 1997, that nation’s citizens who owned gold saw their lifestyle largely unchanged.  Indonesians who kept their wealth in that nation’s currency were pretty much wiped out.

There are a number of Southeast Asian refugees living in my hometown.  Invariably, when I ask them, I am told that they needed gold to pay people who helped them to escape the oppressive regimes they left behind.  I hope things never get that bad in the US, but it is not out of the question that the US dollar may fail some day.  Should that occur, gold and silver coins and ingots will certainly become valued mediums of exchange.

There are many choices to consider in deciding which forms of gold and silver to purchase.  I have a definite bias, being a buyer and seller of physical metals, so I remind readers that the following discussion may gloss over some of the positive reasons for possibly choosing to acquire metals in other forms.  Feel free to do your further research.

With that disclaimer, let me review some of your options.

Gold and Silver Mining Stocks

You could consider purchasing shares of stock in gold or silver mining companies.  This route has some potential for great returns but also for disappointing results.  Often, the returns depend more on factors other than the price of gold or silver.  For instance, the caliber of a company’s management and operations can have a huge impact on stock prices.  You also have to be concerned about environmental issues, political risk, and a number of other factors, which have nothing to do with the prices of precious metals.  Rather than putting your full investment with a single mining company, many investors hold stock in multiple entities, hoping to reduce risk by this process.

Another factor to consider is that the profitability of a mine is determined over many years of production.  There are limits to how much gold or silver a mine could sell onto the markets during a price spike.  Invariably, the metals will be sold at their average price over a period of many years.  This long-term realization of profits is why mining stocks typically do not rise by the same percentage when gold or silver prices are rising quickly.  Conversely, when metals’ prices drop quickly, the stock prices also tend to decline by a lesser percentage.

Exchange Traded Funds (ETFs)

Another option is to own shares of exchange traded funds that supposedly are devoted exclusively to owning either physical gold or silver.  At the inception of an ETF, for example, one share of a gold ETF will typically represent the value of 0.1 ounce of gold while a share of a silver ETF will now normally reflect the value of one ounce of silver (initially, a share of a silver ETF represented ten ounces of silver, but this became impractical as the spot price increased over the years).

If this were exactly how the ETFs operated, they would be a really convenient way to own physical metals.  However, be sure to read all the fine print in the prospectus issued by an ETF.  What you will find is that the ETF invariably has no legal liability for any defaults by any sub-depositories that don’t have sufficient physical metal to meet their obligations.  Further, find out if the ETF is authorized to lease its physical metal, which would add another risk of default of ever getting the gold or silver back.  Last, check if the physical metal that the fund operator carries in its own vaults is considered to be what is known as unallocated metal.  If so, you need to be aware that the metal supposedly owned by the ETF may be subject to superior claims of ownership by other parties.  Altogether, there is more risk that the ETFs may not have the physical gold or silver to cover what it theoretically owes to its shareholders.

Because these are shares of stock of a company that is simply holding assets, shareholders are not charged an annual storage fee.  As a result, most if not all ETFs see the value of one share shrink over time in how much metal they represent as the means to cover expenses.  A gold ETF that started off with one share equal to 0.10 ounce of gold may now only represent 0.096 ounce of gold, for example.

Commodity Contracts

You could purchase commodity contracts on the COMEX or other exchanges.  Many investors buy such contracts on margin, hoping to magnify their results should the price rise on a long contract or decline if the owner holds a short position.  If the market goes against this party, though, losses are also magnified.

However, keep in mind that commodity contracts are mostly traded by investors who never intend to take physical delivery.  Instead, they normally exit their contract before maturity or replace it with another contract with a maturity further in the future.  As a result of this practice, the available inventories held to make contract deliveries only cover a small fraction of outstanding contracts.

COMEX inventories are divided into registered and eligible categories.  It would be most useful to think of these two categories as dealer and investor inventories, respectively.  Registered inventories are committed to be delivered to fulfill maturing contracts.  Eligible inventories are often stored in COMEX bonded warehouses to allow the owner the option to make the metal available to fulfill COMEX contracts, but there is no obligation for the owner to make the commodity available for the purpose.

The inventories that do exist may also be subject to the claims of other creditors.  The COMEX allows parties obligated to deliver on a commodity contract to alternatively pay cash or with shares of ETFs, with the owners of the contract having little to no say on how the contract is fulfilled.

The Commodity Futures Trading Commission is expanding regulation of COMEX gold and silver contracts—including limitations on how many contracts investors can purchase.

London Bullion Market Association Contracts

Another option is to purchase London Bullion Market Association (LBMA) contracts.  This is the largest gold and silver market in the world.  In theory, these contracts are for the physical delivery of metal and are, therefore, 100% backed by the physical gold or silver.

However, in the Commodity Futures Trading Commission hearings held in March 2010, it was confirmed that there is only enough physical metal to cover 1 to 3% of outstanding contracts.  Once again, the physical metal in the vaults may also be subject to claim of other parties.  I have heard regular reports of contract owners being offered cash to settle gold contract delivery (often at a significant premium above the spot price) as the counter party simply did not have the metal to make proper delivery.

Because of the reports of insufficient inventories, some major holders of London contracts from the Far East and Middle East have been aggressively taking delivery of maturing contracts and removing the gold and silver from LBMA warehouses.  This could eventually lead to significant defaults where owners of long contracts will be unable to obtain full value for their investment.

Certificate Programs

There are also certificate programs where bulk gold or silver is stored in a vault such as at the Perth or Royal Canadian Mint.  Customers can buy fractions of the large bars, or in come instances, a portion of un-fabricated metal.  Here again, there is the risk that this metal may be pledged as collateral to other parties.

The Royal Canadian Mint experienced a $17 million disappearance of gold bullion, which after more than a year of exhaustive investigations, was unable to come up with a clear cut explanation as to what happened.

The Perth Mint had a partial ownership in a precious metals firm that may have endured significant losses of gold and silver that it had borrowed from the Perth Mint.  The Mint’s auditors are satisfied that the Mint did not sustain any material losses from this development, but I am not convinced that this is true.  The Perth Mint now owns 100% of this company.

In mid-February 2011, the Perth Mint announced that owners wanting to convert their unallocated holdings into fabricated products to take physical delivery would have to wait at least two months for delivery.

These above forms are ones that I refer to as “paper” gold and silver.  The owners do not literally own the physical metals but instead depend on the performance by another party to eventually convert their paper evidence of ownership into physical metal that they get to hold in their hands.

Physical Gold and Silver

What I consider to be the safest option is to own physical metals in your own name, either in your personal custody or in segregated storage where the metal is considered your asset and not an asset of the storage company.  Direct ownership of the real asset means you hold something that is not someone else’s liability.

However, owning physical precious metals does present the dilemma of safe storage.  There is no perfect answer for everyone.  If you secret the physical metals in your residence, you have some risk of burglary.  If you put them in a safe deposit box, you may have trouble accessing it in event of a disaster.  When a good percentage of the northeast US suffered an electricity blackout several years ago, banks were closed for several days, for instance.  Physical metals in segregated storage in a secure vault may be a long distance away, and not practically accessible in an emergency.

If you do not take delivery of your physical metal purchases, I consider it an absolute requirement that you do not store your metals with the firm that sold them to you.  For more than 30 years, there have been companies who have stored gold and silver for their customers, failed, and left their customers with little or nothing.  Some of these companies were frauds right from the start and some were good companies that turned to crime after suffering losses.

In early 2011, a Montreal-based dealer delivered almost $2 million worth of gold against a payment that proved to be worthless.  This particular dealer emphasizes sales of physical metals to customers who either leave their merchandise with the dealer or sales of Perth Mint and Royal Canadian Mint certificates.  Customers of this dealership who have metals stored by the dealership may soon initiate a run against the firm by withdrawing their holdings.  Those who sit tight may put their investments holdings at risk.

If you own metals directly, avoid unallocated storage.  In this kind of storage, the metal is considered to be an asset of the storage company and the supposed owner of the metal is in reality an unsecured creditor of the storage company (the London Bullion Market Association states this explicitly in its contracts).

I will go into more details another time about which physical metals may best suit your purposes.  As a quick rule of thumb, for most people I usually suggest looking for widely traded forms that are highly liquid, where your cost is the lowest possible premium above the metal value.  In other words, go for bullion-priced gold and silver rather than numismatic forms.

I almost always object to recommending the purchase of what the selling dealer describes as “semi-numismatic.”  In theory, this is an item that costs the buyer a higher premium than bullion-priced items, but supposedly has the prospect of selling for an even higher collector premium in the future.  Of the products that have been marketed as semi-numismatic over the past three decades, almost all of them have been purchased at rare coin prices and liquidated at bullion prices.  Many of them were actually bullion issues that the marketer chose to promote at a higher premium than other dealers were charging.  There are occasional exceptions, but my best rule of thumb is to steer clear anytime you seen the phrase “semi-numismatic.”

By the way, in making this list, I do not intend to give the impression that ownership of only one category is necessarily the best option.  Someone else may hold a core position of physical metals and also buy shares in promising mining companies.  In addition, the time frame of ownership may affect the decision of which form to own.  For someone looking for a very short term holding, say for just one week, ownership of an ETF with its low brokerage fees may be an optimum way to go.

With this information, I hope that some of you are able to take the second step from deciding to own gold and silver to actually making your acquisitions.

Read a follow article covering other options for investing in gold and silver.

Patrick A. Heller owns Liberty Coin Service in Lansing, Michigan and writes “Liberty’s Outlook,” a monthly newsletter covering rare coins and precious metals. Past issues can be found online at http://www.libertycoinservice.com/ Pat Heller is also the gold market commentator for Numismatic News. Past columns online at http://numismaster.com/ under “News & Articles”. His bimonthly columns on collectibles can also be read at http://www.lansingbusinessmonthly.com under “Articles” and “Department Columns.”His radio show “Things You ‘Know’ That Just Aren’t So, And Important News You Need To Know” can be heard at 8:45 AM Wednesday mornings on 1320-AM WILS in Lansing (which streams live and becomes part of the audio and text archives posted at http://www.1320wils.com.