We’re all familiar with the benefits of having a diversified portfolio to help weather the storm in various economic conditions. The goal is to have a number of uncorrelated assets so that at any one point in time you will likely have an outperforming asset class. This helps to temper volatility in a portfolio, which ultimately leads to higher compound growth and returns. Domestic and international stocks (including large cap, small cap, growth and value) are typically recommended equity asset classes in a portfolio, while a combination of U.S. and international bonds (short term and long term) are the preferred fixed income asset classes. However, a very important and oftentimes overlooked asset class is gold; specifically in the form of gold coins.
Demand and Gold as an Asset Class
How is it that a “barbarous relic;” a famous term coined by John Maynard Keynes, that has very few industrial uses, earns no income, pays no dividends, and that is costly to store, serve as a bell weather in the midst of stormy economic conditions? The fact of the matter is that gold is a finite resource that has been used as money for thousands of years. In fact, the United States was on a gold standard until 1971 when Richard Nixon unilaterally closed the gold window.
The demand for gold, especially in Asian countries such as India and China, is as high or higher than its ever been. This coupled with the net buying of gold by major central banks, rising energy prices, and concerns regarding the loose monetary policies of nearly every central bank in the world, makes gold not only a viable asset, but also one whose demand and interest isn’t likely to wane anytime soon.
So now that we’ve established that gold is a legitimate asset class and that global demand for the yellow metal is likely to remain high, why does it serve as a critical component of an investment portfolio? Furthermore, why should one pursue the acquisition of physical bullion, such as gold coins?
Diversifying a Portfolio Through the Use of Gold
As we alluded to above, correlation of asset classes; often referred to as the coefficient of correlation, is one of the key factors in minimizing volatility and subsequently increasing portfolio returns. Historically, gold has had a very low correlation to stocks and bonds; the two most popular asset classes. We have had times in recent history, such as the market crash of 2007, and subsequent Great Recession, where stocks and bonds performed badly. Not surprisingly, precious metals, such as gold and silver performed well during this period of panic and market instability. Gold also tends to perform well in times of high inflation, while bonds are typically the worst performing asset class in this environment.
The reason gold and silver outperformed following the 2007 stock market crash is that investors were seeking a safe haven. Physical gold and silver bullion are the only investments that at the same time aren’t another party’s liability (i.e. they don’t have counterparty risk), which makes them attractive in uncertain economic times. When company earnings collapse and companies begin to layoff workforce, the future prospects of stocks are questionable, at best. Furthermore, when nations are incurring additional debt and funding the debt in the form of bonds, this increases the chance of higher interest rates in the future, which negatively affects the performance of bonds.
Thus far, we’ve addressed the correlation of gold to other popular asset classes and that how in times of economic uncertainty and high inflationary environments, it tends to perform well. However, why not just purchase an ETF or mutual fund that tracks the gold market and be done with it? In other words, why is it prudent to invest in gold coins?
The Gold Futures Market and Physical Bullion Market Are Not the Same
What you may not know is that the spot price of gold is determined by the commodities futures market, which is a paper market. In other words, individuals and institutional investors alike speculate as to what the price of gold will be in the future. Some companies, such as gold mining companies, run the risk of not being able to meet their profit margins in the future; therefore, they may hedge against the falling price of gold by buying a futures contract.
Rarely does delivery of the commodity take place on the contract settlement date. Because of this fact, it’s not essential that the contract be fully backed by physical gold bullion. It should also be noted that when one liquidates their position in a mutual fund or ETF, they don’t typically receive physical delivery of the gold that they invested in through the fund, but rather the equivalent market value of their share. This is even the case even when one liquidates their position in one of the few mutual funds that are fully backed by gold bullion.
This discrepancy between the futures and physical bullion market has oftentimes resulted in large differences between the price of gold bullion, such as gold coins, and the futures market. For example, at the time of this writing, gold coins in Tokyo are selling for approximately $500 over the spot price of gold when measured in dollars. While this isn’t the only example of a variance between the two markets, it’s one that’s of particular importance due to the Japanese yen being a globally traded currency and the strong ties between our economy and Japan’s.
The above comments regarding the physical bullion market relative to the futures market were made primarily to point out that a gold investment in the futures market may ultimately fail to be the diversifier that one counted on in a time of need. To hedge against this risk, we recommend that one invest in physical gold bullion.
What Type of Gold Coins?
Physical bullion in the form of gold coins, such as American gold eagles, South African gold krugerrands and Canadian gold maple leaf gold coins, just to name a few, are not only recognized and valued the world over, but are also guaranteed by the country of issuance to contain the exact weight and purity as indicated in the specifications. This makes investing in gold coins the safest way to invest in physical bullion when attempting to diversify one’s portfolio. While the market for privately minted gold bars and gold rounds is fairly liquid; these items aren’t as widely recognized, which is why the premium on this form of bullion is slightly less than on coins.
In summary, we’ve highlighted the importance of gold in a portfolio, including why it should be considered a separate asset class and how it correlates to other popular asset classes. We’ve also explained how the gold futures market compares to the physical bullion market and why recognizable gold coins, in particular, are the best way to invest in this asset class.