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By and large, the paper gold market dominates the physical one. Gold's price is, for the most part, decided by over-the-counter trading of paper gold. As one of the most liquid assets, upwards of $30 billion of paper gold is traded every day on average.
This is something that gold bugs can't get over. Gold is supposed to be a physical asset free of any counterparty, and yet its digital form ends up driving the price.
If not for the frequent multi-ton purchases by central banks, as detailed meticulously and regularly by the World Gold Council, bullion sales would have a minimal impact on price.
In the broadest of terms, one could say that paper gold is meant for speculators and physical gold is meant for investors. Mining stocks could be called an exception, but many view even them as antithetical to gold investment. For many, gold investment is bullion and nothing else.
Indeed, the further we delve into how the paper gold market operates, the more we understand why so many gold enthusiasts are reluctant to consider it, for all its convenience.
Let's start with an outline of what makes paper gold more akin to a speculative investment.
Understanding the Ownership of Paper Gold
Paper gold refers to any gold investment that doesn't involve actual precious metals, but rather merely products that are backed by them in some form. These can roughly be divided into three categories:
ETFs and Futures
Gold ETFs (or gold exchange-traded funds) are funds that can be purchased on a stock exchange just as easily as you would buy any public company stock. While you don’t own the actual physical gold, these funds are designed to track the spot price of gold.
The SPDR Gold Shares (GLD) ETF for example, was launched in 2004 and can be easily purchased on E*Trade, TD Ameritrade, or any other established broker. Each share of the ETF is backed by real physical gold.
iShares Silver Trust (SLV) issued by BlackRock Financial, is one of the larger silver ETFs. Backed by physical silver, shares of (SLV) can also be purchased easily via any major online broker.
Gold futures are highly speculative investments that money managers often turn to. An everyday, individual investor probably doesn't want to get near these.
Both ETFs and futures have counterparty risk and many view them primarily as a tool for quick gains or, in the case of futures, gauge of market sentiment.
Related: What is a Silver IRA? How to Buy Physical Silver with Your 401(k)
Gold ETF? or Physical Gold?
Digital gold
This is any gold product offered by an exchange that mimics physical gold. Unlike as in the aforementioned cases, digital gold investment is straightforward. An exchange provides a product that tracks gold's price with a 1:1 ratio.
You can purchase, say, an ounce of digital gold, and it will move up and down according to the spot price. As convenient as it sounds, it has plenty of counterparty risk as well.
Mining stocks
A popular way for gold investors to "balance" their exposure to the yellow metal is to allocate half of their gold investment to bullion and half to mining stocks. In this scenario, the bullion does "what gold should" while gold mining stocks offer greater potential upside.
It must be understood, however, that investing in gold mining stocks is no different than investing in any other equity. Both counterparty and systemic risks are abundant.
Instead of merely watching gold's price, the investor now also has to pay attention to how the mining company is doing, as miners can and will go under even if gold is doing well. Therefore, investment in gold miners can prove detrimental even in a gold bull market.
Paper Gold: Too Much Counterparty Risk
In all of the examples above, we can see how investing in paper gold has moved us away from gold's bottom line. We can get some of the benefits and, in some cases, greater upside. But this is mitigated to the downside by various issues that third parties can pose.
Perhaps the biggest problem of all, of course, is that you don't own any bullion.
You merely own an IOU, and a digital one at that. Your digital gold investment is less tangible, less redeemable and less liquid than the very same sovereign currencies people are trying to escape by investing into bullion. When it comes to dependability, their shakiness is roughly in the same ballpark.
Paper gold investment is risky, complex and doesn't demonstrably give you exposure to physical gold. That's why, for all the derivatives out there, individual investors with an eye on the precious metals market will often find it difficult to settle for anything but hard bullion.
Related: Is the U.S. Economic Bubble About to Pop?
Understanding the Ownership of Physical Gold
It would not be wrong to say that the only gold you truly own is physical. We'll touch upon in greater detail why paper gold products don't have the physical gold backing they should or claim to. But even if they did, paper gold still wouldn't mean you own gold: you'd merely own an IOU.
This is why physical gold can't and won't go away. Someone that bought a set of gold coins or bars a decade or a century ago could have stored them however they see fit.
They could have given them to whoever and however they wanted, so long as Roosevelt wasn't watching. They didn't require an intermediary or an exchange. Today, that gold is worth the spot price at the minimum and can be redeemed easily.
Can the same be said for a mining company from the 1970s? Is it still open, or did it go under? What about the exchange you are purchasing your gold derivative on? How will it fare decades down the line? How well is that ETF or mining company managed?
These are considerations that paper gold investors need to make, but bullion ones don't. That's why the two can be said to have a different audience. Paper gold is meant for the price speculator and the portfolio manager. Physical gold is meant for anyone that wants the full benefits of gold ownership.
That's not to say that speculators and portfolio managers don't own physical gold. They'll use it to fulfill the roles that gold should be fulfilling, and use derivatives in an attempt to chase returns as they would with any other risk-on investment.
Physical Gold vs Paper Gold: Market Disconnection
One of the most common misconceptions is that gold only has one price. It has many prices, to the chagrin of many. For example, we have...
- The spot price, which is fixed on a daily basis and meant to represent how much an ounce or gram of gold are worth on a given day
- The futures price, which speculates how much gold might be worth in the near or medium-term
- The bullion price, which is what you're paying when you purchase any physical gold
The first thing you'll notice when buying physical gold bullion is that it has a fairly huge premium. From 10%-20% premium over spot price is the norm, due to a wide variety of things ranging from retailers' fees to manufacturing costs.
With this in mind, it might be accurate to say that the price at which you can buy a gold coin or bar is the true gold price. The spot price serves more as something to go off: you are highly unlikely to ever purchase physical gold at spot price, and if you did so with a proper assay, you'll know you got a bargain.
But this is just the start of the disconnection between physical and paper gold.
The Good, Bad and Naughty of Paper Gold Trading...
Not too long ago, there has been a considerable amount of upheaval over the introduction of the Basel agreement. It's being introduced gradually, because most agree that a full implementation would cause a collapse of the banking system.
When it comes into effect, and the more it does, banks will need to have a provable 1:1 physical backing for all of the gold they're trading over the counter.
Because they have nowhere near it, many believe that gold's price, both paper and physical, is being heavily suppressed by paper gold trading and could explode once the Basel agreement is implemented.
It will be fairly similar to when gold was untethered from the U.S. dollar. Lots of paper and not a lot of gold means gold up, dollar down.
There are many other murky things about the paper gold market why one might want to outright steer clear from it. Stocks have 2x leverage, gold has 31.3x.
That means a $6,000 ounce gold contract is, on the paper market, equal to $187,500. Market manipulation, frenzies and weird action are the norm. Not exactly what one would want from a safe-haven investment.
Who is Paper Gold Right For?
Paper gold is for speculators, stock investors and those that would like to have easier access to gold. If you're a price speculator, gold futures and the like can be a great way to turn a short-term profit, especially if you have a lot of capital as fund managers do.
Stock market investors will likewise find themselves at home investing in gold miners. They'll be exposed to the same risk they usually are and will get the benefits of gold's bull runs more often than not.
If you own physical gold and no stocks, an exposure to miners could be a reasonable way to introduce some risk that makes room for bigger returns with an investment you're familiar with.
Certainly, accessibility plays a role, and we'll soon explain why physical gold investment can still leave some wanting. This is why some opt for things like digital gold and similar 1:1 products.
It gives them quick and easy exposure to gold that tracks the spot price and doesn't force them to worry about storage, insurance and so on.
It's probably the most reasonable out of any paper gold investment, but it's also very limited, as the products more than likely can't be placed in an IRA.
Related: Free Investor Kit - How to Invest in Gold and Silver (Tax-Free)
Things to Know About Owning Physical Gold
Ideally, everyone who wants to own physical gold would be able to do so in a carefree manner. But there are many considerations to make. For all the benefits of physical gold investment, it does come with caveats that need to be taken into account regardless of how much bullion is in the conversation.
Whom are you buying the physical bullion from? Reputable gold dealers are fine, but their offering can be pricey and their inventory can be come-and-go. More often than not, your preferred retailer won't have the exact kind of bullion you'd like to purchase.
You'll have to look elsewhere. And if you're buying from third parties or individual sellers, some kind of assaying will almost always be needed to ensure that the gold is as-presented. That's going to be an additional cost on your part.
Where will the gold be stored? Once you've bought the bullion, you have to figure out a way to store it. You'll need either a safe or vault of your own possession, or one provided by a third-party.
None of these solutions are ideal. Your gold won't always be available, and you'll have to ensure the security of the bullion pile.
Security goes past just an intruder-proof system. If you have a sizable gold hoard that you are storing on your own, you'll also need an insurance policy for it. In the absence of it, if something happens to the gold, your losses will be unrecoverable.
This is why so many opt for either third-party vaults or gold IRA companies when choosing physical gold investment.
Compromising for Convenience
While not exactly a rule, holding physical gold in an IRA presents a kind of compromise. You've introduced multiple third parties that have negated some of the benefits of why you invested in gold in the first place.
Many find this a good tradeoff, however, for what is offered. Many Americans want the tax advantages of holding metals in an IRA.
Since the gold IRA company facilitates both purchasing and storage, you'll have a much easier time handling your bullion.
If you expect to want or need to have your hands on physical gold in a shorter time frame, a third-party vault will probably be a better option. Again, it's not ideal as a counterparty has been introduced, but the more gold you own, the safer you want it to be.
In the end, how you handle your physical gold and silver will boil down to your preference and the amount in question. But we'd venture to say that however and whatever it is, you'll feel better off than if you were dealing with promises and IOUs in the form of paper gold.
