Buying Gold and Your Risk Tolerance

Buying gold bullion for the first time can seem complicated with all the different choices that are available today. However, as with anything complex, it helps to to break things down into smaller steps before making a decision. What follows are some preliminary steps to help guide a first gold purchase.

Research the various ways to buy gold
Earlier posts in our Research category have described the advantages and disadvantages of several ways to buy gold bullion including coins and bullion, mining shares, e-gold, and futures. Each of these have very different characteristics and should be understood completely before making any decisions.

An additional way to buy gold that has not been covered in earlier posts is through Exchange Traded Funds. Exchange Traded Funds are funds that track an index, but can be traded like the shares of a company. In the case of gold Exchange Traded Funds such as the StreetTracks Gold Trust (GLD), they track the price of gold bullion. Exchange Traded Funds enjoy several advantages over other ways to buy gold.

Determine risk tolerance
Once the various ways to buy gold are understood, the first-time buyer should decide how much risk they are willing to take. Of all the ways to buy gold described above, bullion carries the least amount of risk. Unlike shares on an exchange, bullion will never go to zero. On the other hand, your expected reward on a bullion purchase is *relatively* limited as it will never exceed the appreciation in the price of gold.

A step up in risk/reward would be a gold Exchange Traded Fund. Should you pay for your Exchange Traded Fund shares in full, you can expect nearly the same risk/reward profile as owning bullion itself. However, since Exchange Traded Funds trade like company shares, you could take advantage of margin offered by your broker to turn up the risk/reward dial. By borrowing 50% on your Exchange Traded Fund purchase, a 5% move in the underlying price would generate a 10% profit or loss.

Mining shares are another step up in risk. Even if you don’t purchase shares on margin, there can still be considerable leverage involved. For example, a mining company that generates a $10 per ounce profit when gold is trading at $300 per ounce, might realize a $110 per ounce profit when gold is trading at $400 per ounce. In other words, a 33% increase in the price of gold bullion dealers would generate a 1000% increase in the profitability of the mining company. And since the share price of a company should, all things being equal, track the profits generated by the company, one could expect the shares to see a similar appreciation. The company-specific risk of gold shares can be minimized by buying a basket of mining companies available in an index such as the Gold BUGS index (HUI).

At the top of the risk and reward ladder are gold futures. As detailed in an earlier post, futures contain many pitfalls for a novice and should only be considered by someone with prior experience in futures trading.