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Thursday, March 27, 2008

Investing: Including gold in a portfolio

In the previous gnome-o-gram I discussed the function of gold, not as a speculative investment, but as the foundation of a portfolio: the only asset upon which you can rely to retain its intrinsic value regardless of whatever may happen, at least as long as forty centuries of human history is predictive of future events.

This article is addressed to those who have decided to include gold in their portfolios and are now presented with the choice of one or more alternative means of doing so. In the following discussion I explicitly eschew all questions of tax treatment and the possible legality of various options in different jurisdictions: such matters vary all over the place depending upon where you live, and any such questions must be addressed to an expert familiar with the conditions that apply to each individual investor. Regarding taxes, however, keep in mind that we're talking about a disaster hedge foundational asset which you are not going to trade, only buy and possibly add to over time. The only circumstances in which you'll consider liquidating it (except perhaps when moving to a more income-oriented strategy at retirement) would be in times of financial crisis where the value of your other assets has cratered, and in such circumstances taxes are probably going to be pretty low on your list of priorities. If you live in a jurisdiction which imposes a “fortune”, “wealth”, or “capital” tax on assets you own, you should include this among other costs (for example, storage and insurance fees) when deciding how much gold to hold.

Let's start by excluding a form of investment which is completely unsuitable as a disaster hedge foundation: shares in gold mining companies. When U.S. citizens were forbidden to own physical gold (between 1933 and 1974), gold stocks were a legal work-around, as appreciation in the price of gold will generally cause their value to appreciate, both along with their assets in the ground and earnings from sales of the gold they mine. In addition, mines with a high cost of production can benefit from inherent leverage, behaving more like a call option with strike price at their cost of production rather than a zero-based asset. If you have no idea what I just said, don't worry about it, because all you need to know about gold stocks is that they're stocks, and they can go up and down for many reasons unrelated to the price of gold: the mine can cave in, they may discover a new vein of gold on their property or a previous “discovery” may prove to be smaller than estimated, or management can make mistakes in over- or under-investing in production which prove disastrous based on the price of gold in the future. In short, as with any stock, you're buying into a business whose share price depends upon its success or failure, of which the price of gold is only one among numerous contributors. Gold stocks (or diversified funds which hold them) can be an excellent vehicle for speculating in gold, but they are no substitute for the real thing as a foundation for your portfolio and refuge in times of financial peril.

All of the alternatives discussed below are various ways to actually own physical gold. But since this is the twenty-first century, there are different degrees of abstraction involved, and while they make little difference as long as the economy and financial system continue to function normally, they may make all the difference in case of crises. But crises are precisely why you own gold in the first place! So in weighing the various options, it's important to ponder just how bad you think things may get, and make your choices with the intent to preserving your wealth and options in a worst plausible case scenario.

Absent worries about disruptions in the financial system or political risks, the obvious way to own gold would be as shares of the SPDR Gold Shares exchange traded fund, which trades on the New York Stock Exchange (NYSE) under the symbol GLD. Each share represents a beneficial interest in 1/10 troy ounce of gold, and may be expected to closely track the price of gold quoted in U.S. dollars (discounted for storage, insurance, and operating expenses of the fund). Shares of the fund are backed by physical 400 ounce gold bars held in the London vaults of HSBC Bank, with a small fraction of the asset value in short-term cash instruments to buffer sales and redemptions of the fund. Given the listing requirements of the NYSE, regular audits, and centuries of safekeeping of assets in the vaults of London banks, this is about as safe a paper instrument representing gold as one can imagine. Because it is a stock listed on the NYSE, you can buy it through your regular stockbroker, include it in self-directed pension plans, and manage it like any other investment.

So what's the downside? Well, as long as your stockbroker or other financial institution which holds the shares on your behalf, the NYSE which allows you to sell them, the manager of the fund, and the bank in London which holds the physical gold all remain solvent and operational, and no government between you and your beneficially owned gold imposes exchange controls, limits upon capital transfers, or confiscation and/or forced conversion of certain asset classes, there isn't any. But again, it's precisely these kinds of things, among others, which motivate the prudent investor to devote a part of their portfolio to gold in the first place. So while GLD is a convenient instrument for owning gold, if you really worry about “what if?” (and you should), then there are other, more cumbersome alternatives worth considering.

(There is a PayPal-like Internet service called e-gold which allows you to exchange currencies for beneficially owned gold, silver, platinum, and palladium bullion held in storage. This enterprise is headquartered in the West Indies island of Nevis, and has been in operation since 1996. I would consider it an alternative Internet payment system but not a store of value for investment purposes, as it lacks the scrutiny and transparency of a fund traded on the NYSE. I am an e-gold customer, but I use it to make payments, not to store post-apocalypse funds—it's an Internet service—suppose there's no Internet. E-gold, like any other instrument which attempts to avoid the fine-grained scrutiny of governments and reliance upon their paper money, has been the subject of regulatory attacks. See this article for current information, keeping in mind the collectivist inclinations of many contributors to this site.)

We're working our way up the wall of worry here. As I've mentioned, there are a number of parts of the global financial system as we know it which have to be working in order to sell shares in GLD and turn them into something you can use to buy the necessities of life, should it come to that. Risks include the closing of the NYSE on which it is traded (not only was the NYSE closed for six days after the September 11th attacks of 2001, it was closed for four months following the outbreak of World War I in 1914). Further, suppose the government of the country in which you're living up and forbids its citizens to own gold, confiscates any gold they own (including sealing their safe deposit boxes, only to be opened with a government agent in attendance to appropriate any gold they contain), to be replaced by paper money at an arbitrarily specified price, doubtless to be adjusted after the confiscation was complete, at the expense of those who attempted to protect themselves by owning gold. “Paranoid! It can't happen here!”, they say. But for readers who live in the United States, it did happen there: on April 5th, 1933, with no warning whatsoever and without an act of Congress, U.S. President Franklin D. Roosevelt, relying upon a “Trading with the Enemy Act” enacted in 1917, via Executive Order 6102 seized all gold (apart from a few minor exceptions) belonging to U.S. citizens, compensating them with paper dollars at the rate of USD20.67 per ounce. Shortly thereafter, the dollar was devalued with respect to gold to an exchange rate of USD35/ounce, a loss of 41% for any holder of gold before the seizure. U.S. citizens were prohibited from owning gold until December 31st, 1974. If it can happen there, it can happen anywhere, and if it happened then, it can happen now. The prudent investor should bear this in mind when weighing convenience against risk avoidance.

The first firewall one might consider erecting against such calamities is keeping your gold holdings in a different country than that in which you live. This is an excellent idea, as long as the other country is one which is less likely to seize your assets than your own, and is not beholden to it to such an extent that it's likely to enforce your country's strictures against citizens with accounts in that country's banks. Now, that's a heck of a sentence, isn't it? Dude, we're talking about Switzerland. Switzerland has never lost a war in the last seven centuries through the time-tested expedient of never getting into one, and has an unparalleled record of preserving the assets of those who entrust them to Swiss banks across financial and political convulsions which pauperise those who left their assets at home. This is a morally neutral thing: asset preservation means that it works for the bad guys as well as the good guys, but since we're good guys interested in preserving our own assets, we should look at the effectiveness and safety, not at whose name may be on the adjacent box in the vault.

It may seem exotic to have a Swiss bank account, but it couldn't be easier to open one, or to use one to bank by mail or over the Internet. The details of working with Swiss banks are another topic which I may address later, but basically if you write to any major Swiss bank in any language and ask about depositing money there, you will get a letter back in your own language with all of the details. Once you have your account, you can easily make deposits in any currency you wish, buy and sell any stocks, commodities, or any other financial instrument on the planet, or anything else. But let's get back to gold—it always comes back to gold.

There are two principal ways of purchasing gold through a Swiss bank: a metal account, or in segregated storage. A metal account is much like purchasing shares of GLD: you buy a beneficial interest in physical gold stored in the vault of one of the big Swiss banks, and your account is credited with that ownership. As long as the big bank remains in operation, and the bank holding your account is able to process transactions, you can sell your gold for whatever currency you wish. Your only worry is that something may break down which disrupts the record of your beneficial ownership or obstructs your ability to sell it.

If you're worried about that eventuality, you can consider buying gold in segregated storage. In this case, you buy some quantity of gold (depending upon the bank, this may be as small as a single gold coin, or as large as a kilogram bar, which ain't cheap), which is physically stored in the bank's vault (or the vault of a correspondent bank [if this matters to you, ask them]), tagged with your name, and kept in your account. Your account will be charged with storage and insurance fees for this asset. What you get for this extra cost is that, under Swiss law, your gold in the vault is in no way commingled with the assets of the bank. If worst comes to worst, you can walk up to the front door of the bank with your wheelbarrow and say “Ah want ma' gold”, and by law they have to give it to you, and experience says they will. After that, it's up to you to protect it from the hordes of flesh-devouring mutant zombie vampires, but I'm not going there, at least for the moment—maybe after the U.S. elections.

Finally, suppose you've looked at all of the alternatives enumerated above and can see the security holes lurking in them all. What if you insist that your ultimate, “whatever happens”, store of wealth be insulated from any and all intermediaries? How can you own your financial foundation outright without any paper between you and your last-ditch assets? Well, that means actually owning gold—the shiny yellow metalphysically, in your own money bin. That's easy, but also complicated: let's explore the considerations. If you want to buy physical gold, the easiest way is to go to your nearest coin shop (or bank, if you live in Switzerland or other countries where banks understand gold) and purchase gold bullion coins such as the Canadian Maple Leaf or American Eagle coins, which are available with gold content from 1/10 to one troy ounce (the gold in some of these coins is alloyed with other metals in the interest of durability—bullion coins contain the stated weight of the precious metal, not including the other components of the alloy).

So here, at last, is really owning gold! You walk into the coin shop with a wad of paper money, and out you walk with a few coins in your pocket which have about the same purchasing power as they did in the agora in the days of Pericles. What could possibly go wrong? Gnomes exist to point out these things, so let's start with the obvious: somebody could pick your pocket, and then you're out whatever you've spent on the coins. If you get home, then you have to worry about burglars. If you take them to the bank and put them in your safe deposit box, you may fret about a bank holiday blocking your access to that box, or your having to open it in the presence of a revenuer charged with seizing your “hoard” for the common good and compensating you with freshly-printed paper money with no intrinsic value whatsoever, and devalued shortly thereafter.

I'm not trying to induce unwarranted fear here, just to observe that when you're deciding how to handle that small part of your retirement and survival funds upon which you may have to rely if everything else goes south, you should bear in mind that south extends to the gates of Hell and beyond, into the ninth level of financial apocalypse, cross-defaults, breakdown of transaction-processing mechanisms, government intervention into markets and the abrogation of contractual obligations, and instability of valuation and inability to convert paper currencies, and that you might want to consider keeping around, say, three months' household expenditures in physical gold, ideally in the smallest (1/10 ounce) bullion coins, just in case it comes to that, or you need to use those funds to buy a ticket to wherever you've kept the rest of your assets out of the grasp of your own government.

As for protecting these last resort physical assets, I'm sure those who frequent this chronicle are at least as clever as I, and as ready and willing to employ both passive and active measures to that end.

In the next gnome-o-gram, I'll explain what “financial derivatives” are, and why you should be very, very worried about them, even if you've never before heard the phrase and don't own any such exotic financial products yourself.

Other gnome-o-grams

Posted at March 27, 2008 21:03