Buying Gold and Silver on Leverage vs. Physical Ownership

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 |  Includes: GLD, SLV
by: Doug Eberhardt

When it comes to investing in gold and silver, depending on which advertisement you respond to, the sales person will typically push investors towards the product they can make the most money. This tactic is true no matter what industry is involved. Whether it is an insurance salesmen pushing high commission annuities or the financial adivsor pushing illiquid REITs that pay a hefty 6% commission, there is an incentive for the sales person to try and make as much money as possible.

Of course this isn't always the case, but one should be aware of what an advisor makes in commissions and what alternative investments may better suit the investor.

The 3 Types Of Gold Dealers

Gold dealer salesmen come in three types. They either recommend investors buy rare or semi-numismatic coins, bullion bars or coins like the American Eagle one ounce gold coins, or leveraged investments where you can finance your gold investment with as little as 20% down.

I've already addressed gold dealers who sell rare or semi-numismatic coins in several articles (I, II, III). But buyers of gold and silver need to be aware of the risks involved in buying gold or silver on leverage. Unfortunately for most, they don't find out about these risks until it's too late. Not heeding the advice in this article could cost you your entire investment.

Buying Gold or Silver On Leverage

There are numerous companies that advertise on television who sell bullion gold and silver, but once the potential investor calls in, instead of being directed towards buying physical gold or silver, the prospect is steered towards leveraging their investment by using it as a down payment on acquiring more gold than they normally could afford. In fact, the investor can reap the rewards of owning up to 5 times their original allocation.

It works like this. An investor has $20,000 they wish to put into gold. The gold dealer sales person says "how would you like to own 5 times as much gold?" The investors ears perk up as they are already interested in buying gold to begin with. So it's an easy sale to convince them they can earn 5 times as much on their investment. After-all, gold has gone up in price every year for the last 10 years, how can you lose?

Instead of owning $20,000 worth of gold, in this example, the investor would own $100,000 worth of gold. They then would have to pay interest to the gold dealer at the going rate of 5% or possibly higher on the difference ($80,000 x 5%). As long as gold goes up in price higher than the 5% interest expense, the investor is ahead of the game.

But what happens if the price of gold goes down? Does an investor who buys gold on leverage have any risk?

There Are Risks To Leveraging Gold and Silver Investments

Even though the price of gold ended 2008 year over year higher, there were many who bought gold in March of 2008 at the height of the current gold cycle and saw their investment dwindle to nothing. You see, if the price of gold falls by 20% in a certain time-frame, it can wipe out the entire investment of $20,000. And you still may owe for the interest for the time you were fully invested.

In our example, if you had $100,000 worth of gold purchased in March of 2008, and the price fell 20%, you would have a loss of $20,000, your original investment. You would then have to come up with more money to put into your account to keep your investment, or be forced to take your losses.

If this type of risk is too great for you, then buying gold or silver on leverage is not for you.

Even if you put more money into the account, there is always the chance gold could keep falling in price, the result being you are losing money at 5 times the rate of what an outright purchase of gold coins would provide. Gold could also rebound and you may turn out ok over a longer time held. But one should know which type of investor they are before getting into this predicament.

The Physical Gold Investment Alternative

In March of 2008, the investor who bought $20,000 of American Eagle gold one ounce bullion coins at $1,000 each would now be sitting on $6,000 of profit or $26,000 (minus commissions). That's because the price of gold rose from $1,000 an ounce to where it sits today, around $1,300 an ounce. This is the way to invest in gold where you don't take a chance of losing your original investment on any pullback in price.

In fact, if they would have invested this way, the investor could have locked in profit at a higher price earlier this month when an ounce of gold was selling over $1,400 an ounce.

So to recap, the best way to take advantage of this low cost way to invest in bullion is through American Eagle one ounce gold coins. These coins are also easily sold back to dealers without any assaying worries that holders of gold bars have to deal with. And what makes the American Eagle one ounce coins even nicer to acquire is that the buy back price is presently $30 over spot. This means that if the spot price of gold is $1,300 an ounce, the gold dealer will buy back the one ounce gold American Eagle coins for $1,330 each.

Decision Time; Are You A Conservative Investor Or Aggressive?

I have found that most of the people who invest in gold are conservative by nature. Their goal is to make some profit while hedging their risk against U.S. dollar weakness. They also want the most gold for their money and the ability to liquidate their investment without any hassles, which only the American Eagle one ounce gold coins can provide.

One must understand that gold is an overall good investment and insurance against U.S. dollar risk and the government's out of control spending. But when they buy gold or silver on leverage, it is a risk that only those who are well capitalized should be taking.

It's the same story we've heard year after year with the tortoise and the hare. One has to know if they are a conservative or aggressive investor. Only aggressive investors should be leveraging their gold and silver investment. But one can't do this forever. In the end, the tortoise won the race.

The Current Pullback In the Price of Gold and Silver Will See Leveraged Investors Complaints Rise

As the current price of gold and silver takes a breather, you'll see the number of complaints rise against those who sold leveraged investments. There will be a local news story about a little old lady who lost her savings because of this. This little old lady should have never been sold this type of investment to begin with, let alone put all she has into such an investment as gold. If your family member is investing in gold or silver, ask them if they are doing it on leverage. They may not know the risks involved.

Remember, your average investor just doesn't wake up one day and say; "I think I'll go buy some gold on leverage today." These investments are "sold," not bought. Heck, the average investor doesn't even wake up saying they want to buy gold or silver. That's why its important to know what you're getting into when someone on the other end of the phone recommends you invest a certain way.

Greed Goes Both Ways

There will always be the greed of the commission hungry gold dealer sales person in putting clients in unsuitable assets. The same goes for insurance and financial advisors as noted above. If one is educated before investing in gold and silver, they will know what risks they could or should take. Take the risk out of the equation by buying physical gold like the American Eagle one ounce gold coins. Leave the leveraging to those who enjoy risk, but understand they just as well might lose their original investment.

Disclosure: Long Physical Gold and Silver - No Leveraging