Investing in Precious Metals

Precious metals are precious because they are rare. There is a limited amount of these minerals produced each year, and scarcity is the reason for their value. The three major precious metals that trade on futures exchanges around the world are gold, silver, and platinum.

Gold

Gold is the most popular precious metal in the world as individuals and governments, over thousands of years, ascribe tremendous value to the metal that reflects light like no other. Gold has a dual role — it has industrial uses as well as financial applications.

Gold has a high resistance to heat, it is malleable, and it conducts electricity. Therefore, industrial users consume 10 percent of the mine supply of gold each year, including the electronics, dentistry, and medical sectors. Gold has a long history as an ornamental metal and fabricated, or jewelry demand accounts for 50 percent of annual production. Finally, gold is money, and many investors around the world hold gold rather than other investment assets.

Forty percent of gold production each year finds its way into stockpiles or holdings by investors and governments around the world. When investment demand is high, the price tends to rise. Countries own over 30 percent of the gold ever produced in the history of the world as part of their foreign exchange reserves.

While gold production is primary, meaning that companies explore for and extract gold from the crust of the earth as their main business, over 70 percent of the silver produced in the world is a secondary output. Silver is a byproduct of copper, zinc, lead and other metal production. Meanwhile, silver is also a metal that attracts investment demand. Silver has industrial uses as well; solar panels, phones, computers, and other electronic devices all require silver components.

Platinum

Platinum is a rare metal, and while there are approximately 2,800 tons of annual gold production, there is around 250 tons of platinum output each year. Platinum has many industrial applications because of its high resistance to heat. The metal also has a role as a precious metal that many investors hold as an asset.

As investment assets, the three precious metals are different than other commodities. While the prices of other raw materials move higher and lower in currency terms, precious metals often compete against currencies as assets. Currencies around the world are the paper notes and coins printed and minted by governments for use as legal tender.

The currency notes themselves have value because governments dictate that they should. Therefore, it is the full faith and credit of a nation that prints a currency that gives it value. A country controls how much currency flows into the market. However, when it comes to precious metals, it is mine production and stockpiles that determine the availability. Therefore, when people’s faith in governments that print money declines, precious metals tend to increase in value.

Precious metals can be a great addition or a hedge in portfolios for savers. They tend to offset the devastating effects that inflation can have when it comes to nest eggs. There are four main reasons that precious metals should be part of any savings or investment program:

1. When investors lose faith in paper currencies and other asset markets, gold and other precious metals have traditionally retained their values. Therefore, precious metals are a store of wealth during times of uncertainty or economic turmoil and often have a negative correlation with other asset classes.
2. During periods of hyperinflation or government upheaval, precious metals have traditionally been assets that serve as flight capital. During the exodus from Nazi Germany in the 1930s, many people bribed their way out of the country or paid for passage with gold and other precious metals. There are many other examples throughout history where precious metals replaced paper currency as the only acceptable means of exchange.
3. Precious metals have been currencies for thousands of years, while most paper money has only been around for a much shorter time. The long tradition of value for these metals is a testament to their staying power.
4. Precious metals are fungible; they are mutually interchangeable, just like money. Therefore, precious metals are the oldest form of money in the world.

When it comes to investing in precious metals, there are several ways to go.

Physical Bars and Coins

The purest way to invest in precious metals is to buy the actual metals. Bars and coins made of gold, silver, platinum and palladium, another precious metal, are available from coin dealers around the world. Gold bars are available in sizes from 400 ounces down to one gram.

Silver, platinum, and palladium bars also are available in a wide range of sizes and weights. When it comes to coins, many governments around the world mint coins, generally ranging in sizes from one-tenth of an ounce to one ounce that is legal tender in the nation that produces them.

However, the prices for these coins move with the prices of precious metals. Precious metals bars and coins can trade at premiums or discounts to the actual underlying metal prices. These differentials result from the supply and demand for the bars and coins themselves.

When buying physical precious metals, it is important to locate a reputable company. Many dealers and banks advertise on the internet offering physical metals for the retail market. Compare prices between the dealers but be careful, anyone offering precious metals below the market price or at very low prices could be fraudulent. If you are uncomfortable with a dealer, do not purchase from them. It is always better to establish a relationship with a company that can supply precious metals and buy them from you when you choose to sell.

There are pitfalls when it comes to buying and selling physical precious metals, but this is the only direct route to ownership of the asset. As an alternative to taking delivery, some dealers will offer to sell you these metals and hold or store it for you in either allocated or unallocated accounts.

An allocated account will assign you a particular bar or coin while an unallocated account is only a book entry of ownership. If the dealer goes bankrupt or out of business, the allocated account will protect your investment as it is a segregated account while an unallocated investment could become a credit problem and the dealer could default on your purchase. Think of the precious metals market as a pyramid. At the top is the physical market and below are instruments that seek to replicate or move in correlation with the physical metals adding another level of risk.

Futures and Options

Futures and options on futures precious metals are derivatives. These vehicles are the next step down on the pyramid. Futures contracts trade on exchanges, and they have a delivery mechanism for buyers and sellers. Therefore, a futures position can become a physical position in the metals during the delivery period. A buyer or seller can control a precious metals position for a small down payment or margin.

Options on futures are also derivatives that give purchasers the right but not the obligation to buy or sell precious metals. Options are like insurance policies on price. Sellers of options act the insurance company while buyers are the insured party.

ETF and ETN Products

ETF and ETN products trade on stock exchanges and seek to replicate the price action in a precious metal. The most popular ETF products for this asset class are the GLD and IAU that replicate the price action in gold. The SLV is an ETF which tracks the price of silver and PPLT correlates with the price of platinum. Additionally, there are many ETN products in the world of precious metals.

Some will rise when the prices of specific metals rise, and others will rise when the prices of those metals fall. Leveraged ETN products magnify the price action in the underlying precious metals. These vehicles are lower down on the pyramid as they are derivative instruments based on other derivatives such as futures and options contracts in precious metals.

Mining Equities

Another way to invest in the precious metals markets is to purchase shares of companies engaged in the mining for and production of the physical metals. These stocks tend to rise when metal prices move higher and fall when they depreciate. However, those buying mining equities assume additional risks aside from the prices of the metals.

The purchase of a precious metal mining stock is a bet on the management and specific producing properties of a company. If there is a problem with either, the price of the stock could diverge from the action in the underlying metals. Sometimes mining equities outperform the price action in precious metals, and at times they underperform.

When selecting an instrument in the world of precious metals, it is important to do your homework. The most direct route for investment is through the physical market, but the other vehicles offer varying degrees of ease and liquidity when it comes to entry and exit from positions. The thing to remember is to understand what you are buying and selling and the risk of your counterpart.