Over the past decade, few investments have performed as well as gold. Yet those who aren't as familiar with gold investing often find themselves confused by the different ways you can play the sector.
One of the most fundamental questions that investors have to answer is whether they want to invest directly in gold bullion or in companies that search for, dig up, and produce gold and other precious metals. As the experience of the past several months shows, those two ways of investing in gold can bring you much different returns and present vastly different risk/reward profiles.
Sticking with what glitters
For many gold investors, there's nothing quite like owning physical bullion. Whether you buy gold bars or various types of coins, the tactile quality of having gold you can hold in your hands appeals to the senses.
But with bullion investments come added costs. Typically, coin dealers charge premiums over spot price when you buy coins, and may only give you a discounted price when it comes time to sell. If you plan to hold onto your bullion for a long time, that may not be so important -- but if you expect to trade actively in response to changing prices, the transaction costs can really eat into your profits.
In addition to buying costs, you also have to figure out how to store your bullion. Insurance can be costly, and even a simple storage method like a safe-deposit box can add expense.
The costs of holding bullion led to the creation of bullion-ETFs SPDR Gold (NYSE: GLD ) and iShares Silver (NYSE: SLV ) . With each share roughly corresponding to a given number of ounces or fractions of an ounce of gold, silver, or some other precious metal, bullion ETFs own large quantities of bullion on which they pool costs. The expense ratio you pay goes in part toward those costs, but overall, they may be much cheaper than storing bullion yourself.
Buying the diggers
As Warren Buffett has said countless times, though, bullion produces no income. Therefore, many investors prefer gold miners, which like any other business seek out profit-making opportunities.
Obviously, because gold miners have huge asset bases of gold, the prevailing price of bullion has a dramatic impact on the value of their businesses. In general, you can expect prices of miners to move in the same direction as the price of gold.
But gold prices aren't the only thing that affects miners. Mining companies have costs for labor, equipment, fuel, and other parts of the production process. If those costs rise, then profits can fall even if the price of gold stays the same. As a result, mining stocks can fall in a rising gold market.
On the other hand, gold miners can give you much greater percentage returns than investing in bullion. Because of their operating costs, miners essentially provide leverage to investors compared to bullion investments. Ironically, companies such as Golden Star Resources (NYSE: GSS ) and Jaguar Mining (NYSE: JAG ) , which have relatively high cost structures, can end up performing the best in favorable environments -- but they also typically fall the furthest in bad markets.
But you have to be careful to look into how companies deal with their gold production. In years past, Barrick Gold (NYSE: ABX ) hedged much of its gold production, meaning that it locked in prices that turned out to be far below the prevailing price of gold by the time its hedges came due. If a miner hedges, it won't be as sensitive to gold-price movements -- either up or down.
Which should you choose?
Choosing between bullion and mining stocks depends on your outlook as well as your temperament. If you think that gold is poised to rise and don't want to gamble on whether a miner will successfully dig the metal out of the ground, then bullion ETFs give you the purest exposure. But if you want the colossal gains possible when a miner strikes gold, then the right mining stocks will make you happier.
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