How to Diversify your Holdings in Gold

August 14, 2012

If you Trade in Gold, Diversify your Holdings

A key rule when investing for the long term is to diversify an investment portfolio. The advice to move to diversification is the financial equivalent of the old saying ‘never put all your eggs in one basket’.

Consequently, investment advisers will tell a client to spread his money across the asset classes. A portfolio should be split according to assumed risk between equities, bonds, property, and cash. Perhaps within the asset class of equities, an investor would be advised to spread risk across different business sectors. Bond holdings might be mixed between government and the ‘riskier’ corporate sector. Property holdings shared under the banners of ‘residential’ and ‘commercial’.

Very rarely is an investor advised to place funds into gold, and when such advice is given there is never mention of diversification within the asset itself. This lack of recognition that gold is an asset that can enhance or hedge an otherwise diversified investment portfolio is a major contributory factor to the underinvestment in gold.

Why diversify?

We diversify our investments to spread risk. Assets move at different paces to each other, and rarely move together. Decisions that might boost economic turnover and lead to a boom in business might be good news for equities, but bad for bonds. By diversifying a portfolio across asset classes, an investor is, in effect, smoothing his return from the whole pot.

Gold is a great hedge against inflation, and a store of value over the longer term:  particularly when real interest rates are negative. It also tends to trade in a bull market when equities are bearish. So adding gold to an existing portfolio will aid the diversification process and help overall performance.

Perhaps one of the reasons that gold is rarely advised as an asset class in its own right is because of its perceived narrowness of investment. We’ve seen above how it’s possible to diversify within the asset class of equities, for example, by spreading investment across business sector. Few investment advisors recognise that gold, too, can be held in a diversified way by spreading investment across different instruments.

How to Diversify your Gold Holdings

Gold is most commonly thought of in two or three forms.

First there is jewellery, very rarely seen for its investment value. Try telling your wife that she has part of your diversified investment portfolio on her wedding ring finger! But jewellery is a valid form of investment. Not only do you benefit from the value of the gold (and the gemstones set in the gold, where they are), but also from the quality and rarity of the piece. Modern jewellery tends to be valued predominantly for its metal content, whereas antique jewellery has a completely different basis of valuation.

Second there are gold coins, which are more accepted as an investment proposition, though the valuation basis is similar to that of jewellery: the better quality a coin, and the rarer it is, the higher value it will be. Of course, newly minted coins might have a collectability value but will have a greater portion of their price based upon the weight and purity of their gold content.

Thirdly and most commonly used for investment purposes, is gold bullion in the form of bars and rounds. These are valued solely on the gold content, can be stored at home in a safe, or in the vaults of a safe custodian, or in a bank’s safety deposit box. Gold bullion is now available to be bought and sold in a range of sizes specifically designed to make it more accessible to the private retail investor.

So, already it can be seen that holdings of physical gold can be spread across different forms and achieve different returns. But further than that, there are different financial instruments that will benefit from the price of gold in different ways.

Exchange Traded Funds (ETFs) are easily traded on an exchange, through a stock broker, and are be backed by physical holdings of gold. One of the benefits to an investor of having a portion of his gold holdings in the form of an ETF is that the ETF will closely follow the price movement of gold, but unlike physical gold held in the form of coins or jewellery, and even bullion where delivery is required, an ETF can be sold and proceeds realised in just a few minutes.

Shares of gold mining companies are also easily bought and sold, but offer a different perspective for gold investors. These investments will be moved not just by the price of gold, but also other factors such as wages and other expenses, taxes, and the regulatory regime. The discovery of new reserves can massively boost the share price of a mining company. Such companies often mine for other metals and minerals too, so a holding across several mining companies will diversify into other metals. You could, of course, invest in mining companies by buying an ETF based on a holding of mining companies’ stocks.

More speculative and short term diversification can be gained from options and futures on gold.

Finally, investment can be made into ‘digital gold’, an electronic form of gold holdings that can be used to pay for goods and services, or invested in similarly to bullion but without any physical delivery of gold.

Gold: an Asset Class for all Occasions

Gold is not just a great hedge against inflation, nor store of value for the future. It can be used for speculative purposes, to make long and short term gains, or to hedge an existing portfolio in uncertain times.

With the range of products and instruments available to the investor, gold is now an asset that can be used for all investment purposes at all times. Just like diversifying a whole portfolio, an investor should consider diversifying his gold investments to best gain from the yellow metal.