Why You Shouldn't Buy Gold Stocks

by: Cam Hui, CFA

My last post, an embarrassing question for gold bugs, got a fair number of comments - which is to be expected whenever I write anything negative about gold or gold stocks.

My post then deserves a clarification. Supposing that you had a crystal ball that told you the price of gold were to triple within two years. Given this piece of information, what should you buy in order to maximize your gain?

Buying gold by itself will give you a gain of 200%. Buying a two-year call on gold with a $600 strike will give you a projected gain of about 300%. If you change the strike to $900, the projected gain is about 550%.

If you buy gold stocks given the poor fundamentals of rising production costs and their resultant pattern of disappointing leverage, gains are likely to be 200% or less. An investor would be taking on more volatility risk but at the price of little or no incremental gain.

Gold stocks are like leveraged ETFs
There are, however, times that gold stocks can be good trading vehicles. As many readers pointed out, they were a screaming buy compared to bullion early this year. Unfortunately, gold stocks are trading vehicles in the same way leveraged ETFs are trading vehicles. For longer term investors, their risk-reward characteristics are bound to disappoint.