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Gold as Insurance. Why? How?

By: Przemyslaw Radomski | Wednesday, November 28, 2012

Based on the November 27th, 2012 Premium Update. Visit our archives for more gold & silver analysis.


 

We have always put emphasis on the need to diversify while putting together your portfolio. Of various kinds of diversification, one is particularly important at the very beginning, when you decide to commit yourself to the precious metals market. This is the ability to divide your capital into three separate parts, each managed in a different way, and to stick with this structure even when the market is getting hot.

We are of the opinion that such a division:

So what is exactly our suggested portfolio structure? Please, take a look at the table below.

Long-term vs Speculative Capital Table

A short description of this structure:

While the general idea of dividing your portfolio between long-term and speculative capital (the latter is only the money you can afford to lose) is not a particularly new one, the inclusion of the insurance part in the portfolio may make it more robust to financial blow-ups. We will now focus on that - gold and silver as insurance against severe financial turmoil.

Gold may be perceived as insurance if you believe that, because of psychological reasons, it appeals to investors as a wealth-preservation vehicle. In case of financial turmoil they turn to precious metals, the increased demand causes an increase in the price and gold and silver deliver on their promise to provide an alternative to government bonds.

There is also another dimension to it: in the past gold and silver were used as money. As a matter of fact, gold had been indirectly used as money up to 1971 when U.S. president Richard Nixon officially announced that the U.S. government would cease to adhere to its promise to redeem the greenback in gold. Since that moment money has been only paper and a promise of the government to accept payments in it.

Some investors fear that excessive deficits as seen in the U.S. will result in money being printed on a large scale (which actually is already the case: open-ended QE) or even in the implosion of the dollar. The bigger the deficits, the more likely such a scenario seems. This is shown on the chart below.

US Debt vs. Gold (1917-2010)

It seems that since 2000 increases in the U.S. debt have been accompanied by increases in the price of gold. This might reflect investors' fear that the U.S. government will eventually default and their belief that gold may be a safe haven in case of such a development.

The abovementioned points may lead to the conclusion that gold may in fact skyrocket if things get out of hand in the U.S. or in the European Union. The main problem here is that nobody knows when (if at all) the paper currencies will begin to visibly deteriorate or disappear completely. Precisely because of that, we suggest holding on to gold and silver at all times with a part of your portfolio.

We call this part of your portfolio "Insurance," because by holding on to gold and silver even during corrections you accept small losses in hope of enormous gains should serious economic turmoil materialize. Economic crises have the inherent quality of catching most investors off-guard. We don't want you to be among them.

This is, however, not all there is to gold as insurance. Namely, the idea described above only makes sense if the insurance part of your portfolio is put into physical gold, NOT into any kinds of gold futures, options, ETFs, ETNs or CFDs. If the scenario you are insured against (a financial crisis far more severe than the one that started in 2008) occurs, gold derivatives will most likely be rendered worthless or trading rules will change in a way which will prevent you from fully enjoying your profits. What is more, your counterparties could default on their obligations leaving you with nothing at all.

Even though such a course of events seems unlikely, it is still a possibility you need to consider. Particularly if you keep in mind that in the past serious appreciation of metals led to enormous increases in margin requirements for futures contracts. This was the case for palladium in 2000.

Palladium Chart - 1999-2002

In 2000 palladium appreciated from the level of $443 to the level of $956 boasting a stunning rate of return of 115.8%. During that time, however, the New York Mercantile Exchange raised margin requirements for palladium futures contracts in a series of steps which brought the margins as high as to $168,750 for a $72,000 contract. That meant that just to maintain your position open and reap the profits, you had to make a deposit exceeding the size of your position by 133.1%(!) At one point, the Tokyo Commodities Exchange even ceased trading palladium futures and demanded all positions in futures be liquidated.

If this case is anything to go by, exponential growth in the price of gold or silver (possibly 100% in one year) during the third stage of the bull market could result in hikes in margin requirements or in trading restrictions on the part of commodity exchanges. This alone could render paper gold, futures, options and other financial instruments not backed with physical gold worthless or at least suppress their value. And if you realize that your counterparty could simply go bankrupt or default on their obligations, it becomes clear that from the insurance point of view physical gold and silver (or physically backed funds) are the only way to go.

To add an additional layer of insurance to your holdings, you should also diversify your physical holdings geographically. This is an appropriate way to preserve your investments if capital controls are introduced or governments begin to confiscate precious metals.

You can read more on the topic of how to divide your investment capital in our essay on gold and silver portfolio structuring. You will also be able to find an exhaustive list of methods to invest in gold and silver in our guide on how to buy gold and silver.

To read the complete version of this study that is 12 times bigger. Go to gold & silver investment website SunshineProfits.com and sign up for free. You'll find it under Premium Updates.

Thank you for reading. Have a great and profitable week!

 

Author: Przemyslaw Radomski

Przemyslaw Radomski, CFA
Founder, Editor-in-chief
Gold & Silver Investment & Trading Website - SunshineProfits.com

Przemyslaw Radomski

Przemyslaw Radomski, CFA (PR) is a precious metals investor and analyst who takes advantage of the emotionality on the markets, and invites you to do the same.

His company, Sunshine Profits, publishes analytical software that anyone can use in order to get an accurate and unbiased view on the current situation.

Recognizing that predicting market behavior with 100% accuracy is a problem that may never be solved, PR has changed the world of trading and investing by enabling individuals to get easy access to the level of analysis that was once available only to institutions.

High quality and profitability of analytical tools available at www.SunshineProfits.com are results of time, thorough research and testing on PR's own capital.

PR believes that the greatest potential is currently in the precious metals sector. For that reason it is his main point of interest to help you make the most of that potential.

As a CFA charterholder, Przemyslaw Radomski shares the highest standards for professional excellence and ethics for the ultimate benefit of society.

Sunshine Profits enables anyone to forecast market changes with a level of accuracy that was once only available to closed-door institutions. It provides free trial access to its best investment tools (including lists of best gold stocks and best silver stocks), proprietary gold & silver indicators, buy & sell signals, weekly newsletter, and more. Seeing is believing.

Disclaimer: All essays, research and information found above represent analyses and opinions of Przemyslaw Radomski, CFA and Sunshine Profits' associates only. As such, it may prove wrong and be a subject to change without notice. Opinions and analyses were based on data available to authors of respective essays at the time of writing. Although the information provided above is based on careful research and sources that are believed to be accurate, Przemyslaw Radomski, CFA and his associates do not guarantee the accuracy or thoroughness of the data or information reported. The opinions published above are neither an offer nor a recommendation to purchase or sell any securities. Mr. Radomski is not a Registered Securities Advisor. By reading Przemyslaw Radomski's, CFA reports you fully agree that he will not be held responsible or liable for any decisions you make regarding any information provided in these reports. Investing, trading and speculation in any financial markets may involve high risk of loss. Przemyslaw Radomski, CFA, Sunshine Profits' employees and affiliates as well as members of their families may have a short or long position in any securities, including those mentioned in any of the reports or essays, and may make additional purchases and/or sales of those securities without notice.

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