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Gold Investing Mysteries Solved: Terminology and Common Questions

written by: •edited by: Michele McDonough•updated: 9/20/2011

Are you interested in investing in gold but unsure of what terms like "bid-ask spread" mean? Do you need answers to your frequently asked questions? Here's what you need to know for starters.

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    Cromwell Gold Coin 

    If you want to wring more yield from your investments, gold (or any bullion product) is a must for your portfolio because gold is a liquid asset that can be universally exchanged for cash no matter where you go or what you do.

    As the dollar continues to depreciate in value, experts predict that more and more investors will turn to gold as a hedge against inflation and to increase their purchasing power.

    In this guide to gold investing for the novice, we've interviewed two industry experts to get you the help you need to understand the jargon and find answers to your questions.

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    Ask the Expert: Gold FAQs

    If you are considering investing in gold, you probably have lots of questions about the legality of it or what types of products are available. In this interview with Jon Hunt, we'll find out the answers you need to know and his advice.

    Jon Hunt is the founder of BullionSupermarket.com, which is the web's largest dedicated price comparison service for precious metal bullion. Originally trained in computer software, he applied this knowledge to create tools for himself to help find good value physical gold and silver in online marketplaces.

    These tools formed the basis of BullionSupermarket.com, which was launched in 2008. He is a keen investor in precious metals, and holds the majority of his precious metal holdings in physical bullion.

    Bright Hub (BH): Is legal to own bullion? What about the Dodd-Frank act?

    Jon Hunt (JH): Yes. It is legal. There was some initial confusion over the legality of trading in gold and silver derivative products when the Dodd-Frank act was signed into US law, but this has subsequently been clarified.

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    BH: What factors affect the price of gold?

    JH: Just like any other commodity, supply and demand are the drivers, but there are many facets within these.

    On the supply side, the annual production of gold from mines is at best steady, possibly declining, due to increased production costs and diminishing access to below-ground resources.

    On the demand side, traditionally the lion’s share of consumption has been to the jewelry trade. With increasing wealth in countries such as China and India, this has led to increased jewelry demand from these emerging markets. However, more recently, the price of gold has been increasingly driven by investment-led demand.

    To now, this additional investment demand has been met by central bank selling of gold into the market. This has now stopped, and even begun to reverse, with central banks becoming net buyers of gold again. There has also been significant recycling of scrap jewelry feeding demand, but this too is a finite resource.

    As investors look to hedge against currency debasement and wider financial market volatility, investment demand looks to be set to remain the main driver of gold bullion prices for now.

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    BH: Is investing in gold low or high risk?

    JH: Gold is considered a safe haven asset; however, even though the price of gold has risen from around $300 an ounce in 2000 to a high of over $1800 an ounce in 2011, the ride has been a volatile one. There are, therefore, risks for the investor.

    Gold is traditionally a protection against currency debasement and inflation. The world is experiencing a great deal of currency devaluation right now. There is an expectation that inflation will follow. You can print dollars until there is no more paper and ink. You can’t print gold.

    The biggest question anyone thinking of investing in gold now needs to ask themselves is if they think the value of the dollar in their pocket will increase in purchasing power or decrease. If you think it’s going to increase, then gold probably isn’t for you.

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    BH: Are individuals purchasing physical gold or a certificate?

    JH: Individuals are purchasing both physical gold or “gold you can hold”, and “paper” gold, in the form of certificates, gold accounts, or exchange traded funds.

    What option individuals choose may depend largely on their attitude towards accessibility of their gold and counter-party risk. For example, if an individual buys a gold coin or bar there is no counter-party risk once the transaction is completed. However, if an individual buys a gold certificate, gold in an account, or even an ETF, they need to be assured of their legal title to the gold and that the institution holding their gold will still be around when they want to redeem it.

    Individuals' attitudes to counter-party risk have definitely been affected post Lehman Brothers, but that is not to say buying a gold bar and storing it under the floorboards is entirely without risk either.

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    BH: Do they take physical possession or store it?

    JH: That depends on the amount or type of gold purchased. Individuals buying small numbers of gold coins or bars may take physical possession of their gold, and then store it at home or in a security deposit box at their local bank. The box option takes care of security issues, minimizes their counter-party risk, and provides easy accessibility to the gold if they need it.

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    BH: If they opt for storage, what is the risk if the storage company co-mingles the holdings of different clients?

    JH: Again, this comes down to your attitude to counter-party risk. If the storage service provider is okay when you come to redeem, then how they allocate the gold holding will make no difference to the holder.

    If, however, the service provider has problems, gold stored in unallocated pools can be viewed as an asset of the service provider, rather than the account holder, and as such, the account holder may find themselves in the queue with all the other creditors to recover their money. Some service providers do allocate specific gold bars to the account holder, in which case the holder has legal title, not the service provider. Check the small print! The devil is in the details.

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    BH: Are bars and coins the only types of gold bullion?

    JH: Gold coins and bars are the primary forms of gold bullion because they are easily recognizable, verifiable (in respect of purity) and tradable. Other forms such as gold flakes are not really considered bullion as it is not as easy to verify or weigh them.

    Other “paper” forms of gold ownership are not bullion but are backed, in part or whole, by bullion.

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    BH: How is the value of a bullion product established?

    JH: A bullion product such as a bullion coin or bar is valued based on its pure gold content.

    A physical bullion product will usually sell above the value of its gold content, i.e. for a premium. This premium notionally reflects the costs of producing and handling the bullion, but other factors also affect premiums. For example, different types of coins or brands of bars are more popular than others and as such command a higher premium through demand.

    Premiums are heavily dependent on demand and fluctuate, but typically the smaller the weight of coin or bar, the higher the premium. For example, ten 1/10th ounce American Gold Eagle coins will sell for more than a single 1 ounce American Gold Eagle, even though the amount of gold is the same.

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    BH: What happens if the government decides to confiscate individuals' gold? What are the odds that would happen?

    JH: 1933 was the last time the US government confiscated gold from private citizens. The measure required people to turn in their bullion to the authorities for $20.67 per ounce. While there is some discussion on the Internet over such a measure being re-enacted, it is extremely unlikely that such a move would be attempted again.

    Any such legislation would be very difficult to enforce. In 1933, only one person was actually prosecuted under the law, and that prosecution failed. Stories of how in 1933, the government impounded safe deposit boxes are a myth, and that would be as impractical to execute today as it were then.

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    BH: Which types of gold have the lowest or highest spread?

    JH: “Paper Gold” products such as gold accounts or exchange traded funds (ETF’s) etc. will have lower buy sell spreads because you don’t ever take delivery of the gold and dealing costs are minimal.

    Physical “Gold you can hold” will have higher spreads simply because of the extra overhead in handling and dealing. For instance, if you were to buy an American Gold Eagle bullion coin from a dealer, you might pay a 6% or 7% premium over the gold price. All else being equal, such a dealer might buy back from you at, or close to spot, or 0% premium. Therefore, in this situation it pays to buy gold in a form attracting the lowest premium.

    When you do come to sell, you don’t of course need to sell to a dealer. Increasing numbers of Americans are turning to Internet marketplaces such as eBay to trade their bullion where the premium paid when buying can be preserved when it comes to selling. In this situation, the premium paid actually can work for you.

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    Ask the Expert: Novice Investor's Cheat Sheet

    With record prices on gold and other bullion products, many investors are anxious to add one of these precious metals to their investment mix. However, if you are new to precious metal investment products, you may find some of the jargon used confusing or even incomprehensible.

    Here’s a breakdown by Andrew Schrage, editor of the Money Crashers personal finance blog, of some of the most commonly used terminology:

    • Ask: The seller’s offer price.
    • Bid: The buyer’s offer price.
    • Bid-Ask Spread: The price differential between the ask and the bid.
    • Melt value: Value of the gold based on its weight at current spot prices.
    • Obverse and reverse: The heads side (front) of the coin is the obverse; the tails side (back) is the reverse.
    • Spot price: Price investor is willing to pay for immediate (spot) delivery of gold (typically a two-day window).
    • Precious metals: Bullion products such as gold, silver, palladium or platinum.

    Schrage says that most investors opt for coins rather than bars when investing in precious metals like gold since coins allow investors to make much smaller investment at lower weights. In addition, gold coins are easy to store, transport or sell.

    South African Kruggerands or American Eagles are two popular choices with investors. The downside of owning physical gold in bars is when you are ready to sell, you must sell the entire bar as there is no way to liquidate just a portion of a gold bar.

    He recommends holding about 5% of one’s total portfolio in gold, which he considers to be an excellent hedge against market fluxes and one of the best ways of diversifying assets.

    He adds, "Buying gold is a good investment, especially in light of the US decision to go ahead with raising the national debt ceiling, which has caused increased concern for inflation. But before you rush into investing, you need to understand exactly how to invest in gold, what affects gold prices, and the different options that are available."

    For more tips and advice, be sure to check out Bright Hub's Guide to Investing in Precious Metals.

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