Many people who want to diversify into precious metals buy gold ETFs, mining stocks or gold certificates instead of real gold. Unfortunately, not only do these alternatives fall short in the benefits they offer when compared to physical gold, but they also come with added risk.
What are examples of paper gold?
Paper gold is different from physical gold in that any gold in question exists on paper, often effectively serving as a promise of gold. You may think this means that there is an allocation of gold set aside to fulfill the promise if need be.
And yet, as many experts would warn, if tough times were to strike and everyone were to rush to cash in their promissory notes, there is a major chance that the promise will not be delivered.
There are three popular examples of paper gold that people commonly buy: gold ETFs, mining stocks, and gold certificates.
A gold ETF is a share of a fund used to buy one asset—gold. Many investors use gold ETFs as a way to track gold’s performance—specifically in terms of its price trends—without having to pay a premium to obtain the physical product.
If used for exposure to gold’s price fluctuations, a gold ETF may be referred to as a commodity ETF. On the other hand, investors may hold shares to learn more about the gold mining industry’s trends, in which case it is more of an industry ETF.
More advanced traders might go after leveraged or inverse commodity ETFs—again, depending on what specific performance trends they are most interested in tracking. Interestingly, experts often point to gold bullion and gold futures ETFs as performing well, which speaks volumes about the track record of success and potential future performance of gold.
Mining stocks are exactly what they sound like—investing shares in companies that mine specific commodities—and they benefit from higher spot prices of gold and silver while also being affected by the company’s infrastructure, debt loads and foreign governments.
There are two core types of mining stocks to be held: majors and juniors. Majors are very established mining companies, with strong operations and a history of performance. It can be fairly simple to pick a major mining stock that will be somewhat reliable, but there will be little risk—and hence little room for reward.
Junior mining stocks do not have this history of performance. Short on cash and with little track record to show, junior mining stocks effectively stand for mining start-up like operations. The day-to-day performance of junior mining stocks usually has less to do with the gold industry as much as with the variability inherent to a young company’s operations, although overall—of course—trends in the gold industry will matter.
Ultimately, mining stocks tend to reflect the broader movements of the stock market more than the movements in the precious metals markets.
Gold certificates are pieces of paper that can be redeemed for gold.
In the gold certificate market, there is not enough registered gold backing the certificates that are currently being sold and traded. In 2012, there were about 20 claims on COMEX on every one ounce of physical gold in its registered inventories. Four years later, in 2016, the number for COMEX ballooned to 550 paper ounces outstanding for every physical ounce of gold.
Why invest in physical gold over paper gold?
We’ve already touched upon how gold certificates carry some risk since there is insufficient gold compared to what is actually needed to back every certificate out there. But what are some of the other risks that come with the various ways individuals can invest in paper gold?
- Counterparty risk – Counterparty risk is the likelihood that someone in a transaction could default on fulfilling their obligation. Although this is a risk with any investment, it can often be worse with paper gold like gold certificates and ETFs, where there are usually many parties involved.
- Zero liability – ETFs in particular include a note in their paperwork that exempts them from liability for most things that could happen to the shares. This includes terms that can be somewhat loose in interpretation, such as “loss” or “damage.”
- Market risk – While buying physical gold can leave you in direct position of a tangible item with many industrial uses, paper gold is more of a speculation through ownership of part of an entity or object that is more directly susceptible to market fluctuations dictating its worth.You might not always be buying directly into the gold market, especially with options like mining stocks, whose performance is often really adjacent to the precious metal’s performance and may sometimes show independent trends. For example, if you buy into mining stocks and governments change the rules around what gold mining companies are allowed to do, you might see changes in mining stock prices that don’t align with changes in gold prices.
- Poor capital allocation – Whenever you buy a share of a business, you are subject to its management’s decision and its resulting performance.If a mining company’s management decides to build lots of mines—which may not be as a result of gold’s performance—this could affect sales and alter the price of a share. Mining companies may decide to increase their spend while building second-tier mines, despite their having bigger costs over time.
- Diminishing value of shares– In any situation where you are buying shares, there is a risk that the value of each individual share will go down over time, rendering each share less valuable. You will have effectively overspent for the share you end up with.In fact, some experts note that “the large majority of gold ETFs are leveraged 2x or 3x over. That means that they sell two to three times more ETF shares than they actually have gold to back those shares.”
- Lack of insurance coverage – When you own gold and place it with a custodian—even when working through a precious metals dealer—that gold is directly protected by their insurance in a contract between you and the custodian. But with situations like an ETF, the contract with the custodian can get hairy.Because the ETF is not a direct beneficiary of the insurance policy, it claims no ability to control the terms of the insurance; the custodian, then, picks a token insurance policy intended to cover the bare minimum while still being able to claim that they offer insurance. This means that the full value of your gold is likely not even covered by this plan.
- No choice of what gold you buy – Gold can come in many forms, including bars, bullion, proof, numismatic coins, and more. You might see different returns depending on what you invest in; this might be something you choose to explore. With paper gold, you lose this option.
- Loss of taxable income control– This risk is seen with ETFs. Usually, an individual can sell shares in order to carry out tax loss harvesting to reduce capital gains and save on taxes. Individuals who hold shares via ETF can’t make the same move; the trustees determine how to adjust the fund’s portfolio, and individuals may have the option to see the entire lot of shares they own.
Physical gold, on the other hand, does not carry these same risks. Some keys reasons to buy physical gold include:
- Physical ownership – Sure, experts recommend placing gold in a secure, insured depository versus, say, storing it in your basement. However, even when placed in a depository, you are the owner of physical gold that you can claim at any time—which is more than most paper gold ownership offers.
- Purchasing an asset with intrinsic value – Unlike a piece of paper promising a share of a company or some amount of currency that is actually prone to fluctuation, gold is valued and in-demand for reasons beyond its investment potential with applications that include electronics through jewelry. It has intrinsic value.
- Growth potential backed by historical performance – While no investment can come with any certainty, gold’s track record has been steady or better—even when the dollar has suffered.
- Limited supplies could spell future gains – While a mint could always print more dollars or a company could issue more stocks, there is a finite amount of gold in the world. Gold’s scarcity in the face of sustained demand across sectors that include medical and industrial means that there is potential for future gains for anyone holding gold.
- Diversify your savings – Instead of limiting purchases to currency-based assets, buying gold gives you access to a market that operates following different performance trends. By diversifying your holdings, you reduce the overall negative impact to your portfolio that any one asset may have.
- Hedge against inflation or economic downturn – One recent example of this in action came during the 2007-2009 stock market crash, where the S&P 500 performed dismally. Gold not only maintained its value, but the price of gold actually continued to rise even as this crisis was playing out.Even during the 2020 coronavirus pandemic and resulting recession, gold continued the rally it started in fall 2018. Over the course of two years, its price surged 72% and it actually went on to pass $2,000 for the first time in August 2020.
Once you buy it, physical gold is yours to hold and store wherever you prefer. And while gold can be used as a currency, it also serves as a very liquid investment that is highly desired in markets around the world.
Best of all, gold’s historical performance has seen it persist or even grow in value even during times of plunging dollar value and economic downturn. In fact, any breakdowns in the stock market or paper gold market may increase the value of your holdings of physical gold.