John Paulson and the Dangers of Gold Investing

One of the first lessons beginning investors learn is the value of diversification in preventing big losses. But in order to reap the largest gains when they make the right call, aggressive investors often use concentrated portfolios to tap into trends they see as potentially providing explosive growth opportunities.

Unfortunately, those big bets don't always work out. Hedge fund giant John Paulson has learned that lesson well this year with his gold-oriented fund, which has lost 65% of its value so far in 2013. Let's take a look at what happened to Paulson and what it can teach you about taking concentrated positions in your own portfolio, especially in volatile investments like gold.

Image source: Wikimedia Commons.

The Paulson story
John Paulson made his name by making investments that gained in value when subprime mortgages crashed in the lead-up to the financial crisis. Even now, Paulson is keeping a close eye on housing, but lately, he's been playing the space from the other direction with bullish bets on mortgage insurance companies MGIC Investment (NYSE: MTG  ) and Radian Group (NYSE: RDN  ) . His argument is basically that as long as the housing market has hit bottom, prospects for further losses are minimal, allowing mortgage insurers to make up for past losses.

Nevertheless, even though gold makes up only 2% of his overall assets under management, Paulson's PFR Gold Fund remains in the limelight as investors boggle at the scope of the losses the hedge fund has taken. In Paulson's most recent 13F SEC filing of holdings across his entire hedge-fund empire as of March 31, SPDR Gold (NYSEMKT: GLD  ) remained his largest overall position at $3.4 billion, and with the price of gold having sunk more than 25% this year, that has likely created some of the drag on the gold fund's performance.

But even bigger damage came from gold-mining stocks. AngloGold Ashanti (NYSE: AU  ) has lost almost 60% of its value in 2013, with the drop in gold prices having an outsized impact on the gold miner's prospects. AngloGold has also suffered from investors moving away from emerging markets like South Africa in favor of U.S. stocks, as fears of the Federal Reserve's exit from its quantitative easing program have reduced overall risk tolerance among many investors.

Moreover, highly speculative miners have also done badly. NovaGold Resources (NYSEMKT: NG  ) represented a $130 million investment for Paulson as of March 31, and it has lost more than 55% year-to-date as investors question whether the company will successfully get its Donlin Gold project in Alaska off the ground.

What's next for Paulson?
Based on reports of a letter Paulson sent to investors earlier this month, it's unlikely that Paulson will change his overall strategy for the fund. The hedge-fund manager argued that the gold fund still offers the potential for strong returns in the long run, citing the need to protect against macroeconomic factors that could reduce the purchasing power of the U.S. dollar and major foreign currencies.

In Paulson's case, much of the assets managed within the fund belong to Paulson himself, so he likely doesn't have to worry about outside investors seeking to make withdrawals. That should help the fund stick to its long-term strategy, as it's usually pressure from outside investors that forces hedge funds to liquidate positions after big losses.

Is gold safe?
The lesson Paulson's experience has for gold investors is that no matter how convincing an investment thesis might be, making aggressive bets based on that thesis can result in huge losses if you turn out wrong. Gold investors might well have their views proved right in the long run, but putting too much of your money behind your beliefs can put your entire financial future at risk.

On the other hand, now might be the perfect time to look at gold as an investment, after longtime investors have suffered big losses. The Motley Fool's new free report, "The Best Way to Play Gold Right Now," dissects the recent volatility and provides a guide for gold investing, with specific recommendations to take advantage of the yellow metal's recent losses. Click here to read the full report today!

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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 14, 2013, at 10:35 AM, mangobiker wrote:

    Speaking of purchasing physical metals, one difference between them and securities is that the physical metal has ALWAYS had SOME value. So, when governments invariably steal and commit fraud causing the relative value of fiat currencies or securities to drop, they can go all the way to zero. The metals, on the other hand will never go to zero. They have intrinsic of the reasons they were used throughout history by free and prosperous societies as money (including by the USA until 1964). The metals mining sector is much more volatile than the underlying physical metals. Personally, I have had high-flying stocks go to zero, wiping out thousands of dollars. I enjoy ownership of physical metals on several levels, and am not the least worried that the current deflation would have me trade them for fewer dollars and I have no intention of trading them for at least another decade. I do not believe this deflationary depression will continue for another decade. I think inflation, perhaps even rampant inflation could be likely before 2023. Many astute analysts, however, suggest 2025 will be the year that the business cycle resumes with growth. (these are the astute analysts who correctly predicted the world-wide financial crisis starting in 2008, not the clueless, bumbling idiots who caused it (Bernanke, Paulson, Geithner, Bush, Obama). Regardless of when the day of reckoning comes to the US dollar, owning some metals remains a prudent diversification.

  • Report this Comment On July 14, 2013, at 11:23 AM, ExposeIdiots wrote:

    Another ridiculus story. Just ask China, as they have imported 1500 tons of physical gold in the last 7 months. they're laughing all the way to the depository, thanks to the American stock market and all the paniced idiots that call themselves stock experts. Get a clue.....the dollar is worthless, and soon stocks will be as well. Gold backed currency is on the way.

  • Report this Comment On August 13, 2013, at 12:51 PM, rkells wrote:

    How much gold do i need to invest in to make it worthwhile and is platinum and silver a good investment

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