Blogs | February 1, 2017

Is physical gold less risky when it comes to investing?

Chris asks: Is investing in gold on paper more risky than buying physical gold due to counterparty risk?


Ian answers: No, it is not. This is not true. Let me begin by explaining what counterparty risk is. Counterparty risk is the risk that a company or person you have a contract with cannot meet the terms of the agreement. For example, if a builder hired to do repairs goes out of business before completing the work, this constitutes counterparty risk.

The risk is that money involved in the deal will not be repaid. In finance, this is also known as default risk.

Counterparty risk has always been a feature of financial markets. To offset this, exchange markets set up central clearing houses. If members of an exchange cannot meet their obligations, other members step in to make sure the contract is fulfilled. What happens typically is that the other members take away the assets of the member in default. This was a plot element in a 1983 Hollywood film, Trading Places.

People usually buy paper gold through a contract that is backed by a formal exchange arrangement.

The name’s Bond
Buying gold coins or gold bars might sound thrilling – as if you’re living like a glamorous spy hero from fiction, like James Bond or Modesty Blaise. But it can be a hassle. First, you will need to buy your gold from a specialist dealer. This means fees. These immediately cut into your investment.

Second, physical gold needs to be stored safely. A small amount might be kept in a rented safety deposit box; larger ones in space in a vault. Once again, fees are involved. Smaller amounts could be stored at home but the possibility of theft should not be ignored.

Thirdly, suppose you want to actually use this investment. Coins and bars cannot be physically broken into smaller amounts, so you might not be able to get out the exact amount you want. And you will need to visit a specialist dealer again; that means more fees.

What’s more, there is no guarantee a dealer will want to buy the gold at the time you wish to sell. Your investment could be illiquid.

Along with with the storage and security concerns related to actual gold, there is a possibility that you might begin to overvalue it, because of a common bias towards things you actually own known as the endowment effect. Research also suggests that if you actually touch the physical gold, the effect can increase. Learn more about how the endowment effect changes our thinking here.

What are the alternatives?
Investing in gold through an investment product such as a mutual fund or exchange traded fund (ETF) gets around these problems. You will still need to pay fees for the privilege, but many investment products have been standardised and competition between providers can keep the costs lower than when dealing with specialists.

But there is always risk, whether you invest on paper or in actual physical gold. The gold price can change rapidly and you do not get paid any dividends or interest.

All that glistens …
You will often see websites and blogs arguing that physical gold is better than paper. Many seem to base their concern on the potential for widespread collapse of the financial markets. No doubt the global financial crisis of 2008 onwards influences these writers - but if it ever came to a total meltdown, surely fresh water, a tin of baked beans and a can opener would prove more valuable.

InvestingGold

Ian Bright
Ian Bright

Senior economist at ING
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42 blogs

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