10 rules for investing in gold

[K.Karthik Raja]

10 rules for investing in gold

Timothy Green, a well-known international gold expert, reminds us of a
historical truth: "The great strength of gold throughout history has
not been that you make money by holding it, but rather you do not
lose. That ought to remain its best credential". A research study on
gold established a remarkable consistency in the purchasing power of
gold over four centuries. Its purchasing power in the mid-twentieth
century was found to be nearly the same as in the middle of the
seventeenth century.

An investment in gold should be based on macro economic con-
siderations

If one expects or fears rising inflation, destabilizing deflation, a
bear market in stocks or bonds, or financial turmoil, gold should do
well and exposure is warranted.

Understanding the internal dynamics of the gold market can be helpful
as to investment timing issues

For example, the weekly position reports of commodity trading funds or
sentiment indicators offer useful clues as to entry or exit points for
active trading strategies. Reports on physical demand for jewellery,
industrial, and other uses compiled by various sources also provide
some perspective.

However, none of these considerations, non-monetary in nature, yield
any insight as to the broad market trend. Reports of central bank
selling or lending may influence the market in the short term but
cannot counteract macro economic factors.

Excessive reliance on trading strategies to generate returns can be
dangerous and counterproductive

Returns from a 'buy and hold' strategy should be more than sufficient
to compensate for the inherent volatility. Many who have tried to
outsmart this market by hyperactive trading have under-performed.
Success is de-pendent in large part on the occurrence of 'fat tail'
events that lie outside the parameters of trading models.

Every investor should have some gold

A reasonable allocation in a conservative, diversified portfolio is 0
to 3 per cent during a gold bear market and 5-10 per cent during a
bull market.

Equities of gold mining companies offer greater leverage than direct
ownership of the metal itself

Gold equities tend to appear expensive in comparison to those of
conventional companies because they contain an embedded option
component for a possible rise in the gold price. The share price
sensitivity to a hypothetical rise in metal price is related to the
cash flow from current production as well as the valuation impact on
proven and probable reserves.

Watch out for companies that have hedged their gold exposure

Although a rising tide may lift most boats, financial statements
should be reviewed with special attention to hedging arrangements that
could undermine participation in higher gold prices or even jeopardize
financial stability. The carnage of the last twenty years has
simplified the task of individual stock selection because so few have
survived the gold bear market. But individual stock selection is less
important than identification of the primary trend.

Don't get caught up in gold fever

Even though gold itself is a conservative investment, 'gold fever'
attracts a crowd of speculators, promoters, and charlatans who only
want to separate investors from their money. Avoid offbeat
'exploration' companies with little or no current production and
gargantuan appetites for new money.

Bullion or coins are a more conservative way to invest in gold than
through the equities

There is also greater liquidity with bullion for large pools of
capital. Investing in the physical metal requires scrutinizing the
custodial arrangements and the creditworthiness of the financial
institution. Do not mistake the promise of a financial institution to
settle based on the gold price, for example, a 'gold certificate' or a
'structured note' (i.e., derivative), for the actual physical
possession of the metal. Insist on possession in a segregated vault,
subject to unscheduled audits, and inaccessible to the trading
arrangements or financial interest of the financial institution.

Gold is a controversial, anti-establishment investment

Therefore, do not rely on conventional financial media and brokerage
house commentary. In this area, such commentary is even more
misleading and ill-informed than usual.

Don't settle for too little

Should outlier events now deemed unimaginable by consensus thinking
actually occur, the price target for gold would be several multiples
of its current depressed price. Gold represents insurance against some
sort of financial catastrophe. The magnitude of the upside is a
function of the amount of paper assets that would be converted to gold
irrespective of price..