All that glitters: What does “buying gold” mean?

“Just forget about it guys, go do something else.”

This was the advice an investment banker in the mining sector said he’d like to impart when he gives a speech next week on his industry to MBA students going into mining. And he didn’t have any sunnier words for potential investors: “Mining is like a lottery. You can win big, but chances are you won’t.” He took the lottery comparison further, suggesting that mining’s low profit margin means it constantly sucks up large amounts of capital to function while returning little of it to the average investor.

Though mining as an industry is currently in a down-turn, the banker insists that his comments apply in more prosperous periods too. All of this struck me as extremely odd. While the price of gold has taken two big falls and a series of little stumbles over the past six months, it is seen by the general public as one of the “safer” investments. Investors tend to turn to it in times of instability, to safeguard against rogue currencies and capricious markets. In India the national gold fetish has caused a massive current account deficit and distorted the value of the rupee. And if Rand Paul and others of the libertarian persuasion want to reinstate it as the standard by which to define the value of the worlds’ currencies, they must have good reason for wanting to do so.

All of this raises a few questions for me. First of all, what does it mean to buy gold? When one invests in gold, is one investing in the actual material tucked away in a safe, or rather must one invest in the mines that extract it or in an ETF tracking a multitude of mines? “Investing in gold” is such an abstract phrase, for me at least, that it bears examination.

The short answer to this question is, anything goes. One can invest in bullion coins, bars, or even jewelry, from dealers (Forbes’ Nathan Lewis outlines the entire process here), which will usually Fed Ex the gold to a chosen destination. This can be a bank, a safe storage company of the owner’s choosing, or even a home safe. (Insert snarky quip about libertarians storing gold at home here.) There are also virtual gold ownership options in which the company holds gold for the owner, and ETFs that track gold’s cost. However, Lewis warns against these options, because in the event of the bankruptcy of a broker, it would be nearly impossible to recoup the investment. As he rightly points out, when one possesses physical gold, it is possible to see “just how abstract and tenuous most investments are.” ETFs are seen more as a speculative bet on future gold prices, as are gold futures contracts; both investments more closely resemble Keynes’ famous casino (in which agents act based on their predictions of other agents’ actions) rather than our investment banker’s mining lottery, which applies more to the next gold investment option.

2 Chainz: Sustaining the gold industry since 1977

The “lottery” route to gold ownership is through investment in mining companies. A quick scan of most major mining companies’ balance sheets will show why: many of them are loaded up on debt due to the capital-intensive nature of the industry. One of the larger firms, Barrick, has a whopping $14 billion in long-term debt. Forbes observes that gold mining companies have underperformed both the broader market and gold itself consistently for eight years, despite gold’s soaring price during that same time period. It would stand to reason that gold miners would take off at some point, but rare are the instances in which common sense holds up in markets. In the case of gold miners, it seems the complex logistics of the industry have managed to erode its profitability, and the situation is critical now that gold prices have fallen so drastically. On the upside, however, most analysts say gold miners have nowhere to go but up, making them a wise choice for anyone who enjoys lotteries with particularly long odds. Gold miner ETFs are available too.

So the differentiation between investing in gold and investing in gold mining is important in understanding our banker’s bearish comments. My initial confusion came from conflating the two, though now I have another question: If gold is reckoned by most to be a secure store of value in times of instability, and (by some) the standard by which currency should be measured, then how to explain its spectacular fall?

Ben Bernanke, the current Chairman of the Fed, had this to say: “Nobody really understands gold prices and I don’t pretend to understand them either.” Many analysts affirm that gold’s price is largely based on emotion. That’s a pretty risky thing to chain a currency too, though it could be argued that a floating currency’s value also has a lot to do with investor perceptions. The price of gold seems to be loosely connected to the level of perceived instability of markets and political conditions–this would partly explain why gold has been in a bull market since 2000, and from then it quadrupled in value over the next nine years. Gold now trades for around $1300 an ounce, down from over $1900 in 2011. The Fed’s announcement in May that it might soon begin tapering QE may have exacerbated gold’s precipitous fall by attracting investors partial to “safe” investments back to the US bond market with the promise of higher returns. Additionally, the Fed’s comments could be seen as a harbinger of the end of the uncertainty that the recession perpetuated, thus making gold’s function as a safeguard against instability redundant.

Proponents of the gold standard amazingly still abound. Most of these are libertarian-leaning Republicans who regard inflation as theft. This too is an emotional issue for some. Even after the price of gold tumbled twice within two months, which should clearly signal the fact that no commodity is sacred, Republican politician Rand Paul insisted that his father’s pet gold standard platform be reconsidered to combat the dreaded inflation beast, commenting that “we need to think about our currency that once upon a time had a link to a commodity and I think we should study it.

Despite recent events, it is unlikely that gold will lose its relevance anytime soon. If the US does in fact default on its debts, gold may enjoy a swift recovery, as might the mining sector. Whichever way gold goes, Mr Paul is unlikely to give up his crusade to reinstate the gold standard. And as for the banker in mining, he’s just grateful for the extra free time to work on his speech.

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