July, 2008

Advice on Buying Gold

Owning the Physical Metal vs. Investing in Gold Stocks

Assuming you have already decided to own gold to diversify your overall portfolio, you may then ask the following question. What form of gold should I purchase? Should I buy physical metal such as bullion coins or bars, or would mining stocks be better?

We recommend owning a combination of both physical metal and mining shares to maximize performance, and minimize risk. Owning physical metal enjoys certain advantages over owning the mining stocks and visa versa, but in combination provides the best way to protect and grow ones portfolio in difficult and uncertain financial times.

Gold investors must choose for themselves how to split up their gold allocation. It is important for investors to be certain that the gold items they own are the ones that will best serve their purposes. While each investor's circumstances are different, the discussion that follows should give you some ideas on how to best divide your gold holdings.

What are the differences between owning physical metal and owning stocks?
The obvious difference is risk. On the investment pyramid of risk, physical ownership of gold would be on the lowest tier (least risk) with cash and life insurance, while ownership of gold mining shares would be classified on the second or third tiers (higher risk) depending on whether you own a major gold producer or a junior mining company.

In general terms, owning physical metal is more of an investment (savings) while owning mining shares would be considered more speculative. However, with increased risk comes greater opportunity for return, thus our recommendation to own some of both.

During a bull market in gold, the physical metal prices will go higher, but the gold mining shares are leveraged to the physical price. In other words, as the price of gold rises, profits from mining stocks rise more in percentage terms.

Generally, over the longer term, the share prices of the major gold producers rise by a factor of two to three times more than the price of gold. Successful junior mining companies can rise by a factor of 5 to 10 times more than the price of gold. The reason for this leverage is that a rising gold price does not lead to a rising cost of production.

Therefore, for companies that are already profitable, incremental revenues received from selling gold at a higher price flow straight to the bottom line. For mining companies that are not profitable, a rise in the gold price can suddenly lift them into profitability and a much higher share price.

A second factor to remember is that a gold mining share is not gold. It is a stock first and gold second. A gold mining share is NOT a substitute for the physical metal. It represents a claim against gold in the ground and not the gold itself. Stock ownership has inherent risks that are associated with all stock investing. Stocks often represent debts, liabilities, risks - monetary, environmental, political, etc. Physical gold is an asset, the only financial asset that is not simultaneously someone else's liability. Owning physical gold is essentially risk-free as long as you retain possession. Sure it can go up or down according to market fundamentals, but you can hold it securely in your hands. Physical gold does not need cash flow or management to insure its ultimate survival.

Some other items to consider:

• Physical gold ownership does not pay dividends. Mining stocks can pay dividends when profitable.
• Physical gold ownership has protected investors during periods of economic depression, wars and political unrest. Mining stocks could be negatively affected in such times as stock markets may be closed for a time.
• Physical gold can be used for barter or purchasing life sustaining items during crisis times. Mining shares would be harder to use for such purposes.

Various forms of physical gold ownership
There are four basic categories for owning the physical metal itself. They are as follows:

1. Bullion coins issued by various governments. (ie. American Eagles, Austrian Philharmonics, Canadian Maple Leafs)
2. Bullion bars of various sizes and fabricators
3. Numismatic or collector coins
4. Pre-1933 World gold coins (British Sovereigns, Swiss 20's, French Roosters, etc.)

From our perspective, unless you are a collector, we advise that you do not buy numismatic coins for the purpose of diversifying your portfolio. The transaction costs or mark-up can be up to 100% over the spot price of the metal, whereas bullion coins, bars, or world gold coins are typically 5% over the spot price.

For most investors the one-ounce bullion coins offer the best value. We recommend buying the American Eagles, the Austrian Philharmonics, or the Australian Nuggets as they are all exempt from a 1099 when you sell them. These items would be considered a private transaction. We also like the Pre-1933 world gold coins for the same reasons, they are just smaller in size (usually one quarter to one fifth ounce of gold), and because they offer some protection in case of a potential future gold confiscation.

Bullion bars are fine if they are purchased in smaller sizes such as one ounce or ten ounce bars from a well-known fabricator. There are some bar fabricators that encase the bars in plastic and include a certificate number of authenticity. Bars of this nature would be preferable to bars without such a certificate. They can be purchased for a little less than the one-ounce bullion coins mentioned above but can incur a 1099 when sold in quantity.

Conclusion
As investors we need to consider what our objectives are for holding gold before we can correctly decide what items to purchase. Some people who are more savings oriented, tend to emphasize owning the metal, while others who are looking to make a big return, tend to emphasize the mining stocks. For the money that you have to invest in gold, we generally recommend 50% in physical and 50% in mining shares.

Mining stocks can produce spectacular returns at times, but can also show lots of volatility. Make sure do your own due diligence and never put more than 10% of your money into just one stock.

Hopefully the information provided above will help you in your investment choices for capital appreciation and preserving one's wealth.

You can download the PDF version here: Advice on Buying Gold

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