Gold 101: Do You Pass?

Includes: IAU
by: Quoth the Raven

Gold is arguably in one the of the biggest bull markets in history, with inflation and the Fed fanning the flames with quantitative easing. Gold has had an astonishing run over the last 10 years, as I've pointed out in a lot of my bearish sentiment articles.

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As I've stated in a couple of recent articles, gold remains a great hedge against financial meltdowns. The purpose of this article is to go over the basics of gold again, and identify some interesting characteristics of gold that people may not have thought about or considered. As time moves on and the Fed starts its QE tapering (in my opinion, it starts in mid- to late 2013), people are going to start looking into gold as a safe haven for their money again. My question is: Would you pass Gold 101?

One of the first things that I found out as a novice investor was that gold stocks are much riskier than gold itself. ETFs that include gold mining companies often move with much wilder swings than the underlying commodity. Individual stocks are even riskier. I was in and out of Great Basin Gold a couple of times before its total downfall, to give you an example. It's important to remember that gold stocks can go under even when the underlying commodity does not. You have to remember that you're betting on a gold-based business when you buy the stock, not the commodity price directly.

R.I.P. Great Basin Gold

However, gold remains the perfect hedge against financial meltdown. As early as the 1970s, gold was being used as a major hedge against inflation and it was working effectively. During the beginning of 2011, gold had a massive rally on the news of the U.S. debt being downgraded and economic issues overseas. The fact that gold never really moves in direct correlation to stocks or bonds makes it a great place for a permanent small part of your portfolio.

Buying actual gold isn't just safe -- it's pretty cool. If you find a dealer or broker that has been established for many years and has small premiums, you can easily build a physical gold position. Take a cue from the way that the large banks operate. The same way that banks hold the precious metal in reserve is could be used as a macrocosm of how you hold gold in reserve. Why not take a small physical position and store it in a home safe or security box at your local bank?

Physical gold is great because it's known worldwide, and will always have some sort of value because it's non-renewable. The small list of cons of physical gold basically revolve around the inconvenience of having to physically buy and sell it, as well as having a secure place to store it. Also, gold doesn't pay dividends or have any guaranteed yearly yield.

The other common way to invest is through gold ETFs such as iShares Gold Trust (NYSEARCA:IAU), which basically track the price of the commodity by physically purchasing bullion. ETFs are an incredibly easy way to trade gold in the account that you already have and can be traded very quickly, unlike physical gold. Gold ETFs are a much quicker and much more convenient way to trade gold (and other metals).

Arguments against ETFs include the fact that it cannot be simply traded for gold, it's not a great hedge against stock volatility, and there's usually a management fee associated with gold ETFs. Questions are often raised about the fact that gold ETFs don't necessarily need to disclose the actual trust holdings, in terms of how much gold they actually have in trust. If you're holding physical gold, you know exactly what your personal holdings are because you can just open your eyes and take a gander whenever you please.

Due to the fact that gold has simply worked well as a long-term hold, buying with the intention of holding 10, 20, or 30 years isn't necessarily a bad idea and may seriously reduce your risk:

So, there is some short-term risk associated with gold, although this investor sees the risk decreasing with the longer you intend on holding your gold position. Since gold has peaked in 2011, it's been down nearly 35%. I contend that these short-term pullbacks are normal, as analysts (for whatever reasons) continue to upgrade and downgrade gold. Corrections are fine when the long-term price trend is steadily heading upward, like gold continues to do. Savvy investors that are long gold see these dips as a chance to add to their respective positions on the way up.

I would argue that this is the perfect time to take a position in gold, due to it being 35% off its highs and due to its long-term appeal. QTR recommends holding physical gold to ETFs about 75%/25% of your gold position, which should total, in my opinion, about 5%-10% of any and every portfolio at all times.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.