Don't Mistake Your Silver for Gold, Central Banks Don't

by: Kevin Feldman

While silver continues its wild ride, I thought it would be good to revisit some of the key differences between silver and gold.

In the past 16 months, the price of gold has risen about 35% — an impressive gain. The price of silver, however, has skyrocketed, approaching a 123% gain (as of 5/10/2011). Some analysts argue this is merely "silver catching up to gold" because the price of gold had already steadily climbed to a point where investors were looking for another precious metal safe haven. Silver, once known as "the poor man's gold," had now become "the new gold."

Except that it really isn't. The two metals have some similarities — many investors see both as a hedge against inflation and currency devaluation — but from an investment standpoint, their differences are probably more important than those similarities.

Let's look at a few of those differences:

The supply of gold is extremely limited; the supply of silver is not.

Much of the world's known supply of gold is already above ground. It is practically indestructible and has limited commercial use — most of the world's gold is either in storage or in jewelry — so it's constantly being recycled. There is, on the other hand, a large supply of silver; it's obtainable both directly through silver mines and indirectly as a byproduct from other commodities being mined. Silver mining is responsive to demand, and as the price of silver has risen, new mines have opened in places as different as Brazil, Africa and even Texas, where a mine reopened after being closed for over 60 years! As you can see in the chart below, silver mine production was already rising (up 2.5% last year). The output of new mines will enlarge the silver supply even further and could reduce future prices.

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While many private investors may think of silver as a hedge against inflation and a form of money, the world's central banks do not.

The world's central banks store gold as a foundation for their national currencies and have recently been net buyers, increasing their gold reserves. That's not only an enormous source of demand for gold, but at the same time a reason why much of the world's gold supply doesn't circulate on open marketplaces. I haven't been able to find any consolidated published central bank holdings of silver as a reserve. I had to go back to this 1923 report helpfully furnished by the St. Louis Fed to find a time period when central banks viewed silver on par with gold as a reserve.

Historical patterns demonstrate that the prices of silver and gold don't always rise and fall together.

Gold has had price volatility that is more than bonds, but slightly less than equities. But the price of silver has been much more volatile (as shown in the chart below) and sometimes in a completely different direction than gold. Take 2008 for example, when the price of silver declined 27% and the price of gold rose 6%. This is the reason many advisors allocate a small portion of an investor's portfolio to gold–because of its historical diversification benefits, especially during turbulent market cycles.

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Does all this mean that there's no good case for silver? Not necessarily. Given the industrial usage of silver as the economic recovery continues to gather steam, there remains a case for silver; you just need to be rational on your expectations and time horizon for future returns given silver's rapid ascent the past year.

And remember that silver is likely not a good longer-term substitute for gold based on fundamental and historical evidence. Investors who see both gold and silver as a precious metal safe haven should remember their key differences.

Sources: Morningstar Direct, Bloomberg