Consumer champions like ThisIsMoney and Money Box regularly report on people who’ve come unstuck with an investment scam, pseudo-bond, or other moneymaking scheme.

These media outlets do a good job highlighting dodgy financial advice – and outright scammers and crooks.

But too often it appears that neither the punter nor the journalist is aware of the investing risks that were being taking by these hapless members of the public, even when a particular scheme was legal.

Typically the victim – Phil, a 52-year old school teacher, Camilla, a 33-year old care worker, or Basey, a 19-year old student – doesn’t seem to have thought very hard about where they were putting their money.

They wanted easy gains, and they brushed aside any thoughts of investing risk.

I’m not saying there aren’t criminals after our money. Even the legitimate financial services industry has its sharks.

But we have to take responsibility, too.

As I look at the doleful portraits in a newspaper story about an investment scheme gone wrong – perhaps a ripped-off stay-at-home mum miserably holding a tomcat, and being hugged by a supportive but excessively bearded spouse – I have some sympathy.

But often only some.

Many people seem to spend more time deciding how to cast their vote for The Voice than they do thinking about investing their money.

And their aspirations can be crazy:

• “Sure, buying farmland for £10,000 that in two years will be worth £100,000 when it gains planning permission seems like exactly the sort of brilliant investment opportunity I deserve – and that should just fall into my lap via a cold phone call!”

• “I don’t know much about platinum mining in South Africa, but I like the sound of 15% a month!”

• “I work hard! Why should I accept 1% a year in a rip-off cash savings account when I can get this Triple Enhanced Gilt-Reinforced Trusted Society Bond paying 10% with just some technical small print about my capital being at risk?”

• “Better than Bitcoin? Make mine a double!”

Such foolishness makes it harder for the rest of us.

Perhaps even worse is their tendency to go all-in with their life savings.

Never go all in. Assume every investment can fail you.

I wouldn’t even put all my wealth into the behemoth of trust that is Vanguard.

Yet some of these people will apparently sign everything over to a stranger who knocks on their door on a Wednesday night.

One investing risk or another

I’m probably being mean. It’s often pointed out that people who fall victim to scams often do so because they’re otherwise sensible who didn’t realize they’d wandered into enemy territory. In other areas of their life they’re competent, and that breeds a complacency.

There but for the grace of the regulator go I, and all that.

Yes, there are people with a lifelong history of chasing unicorns and rainbows to a steadily impoverishing affect. I’ve met a few.

But other people were just trusting or naive at exactly the wrong moment. The world would be a sorrier place if it was only populated by grizzled financial survivalists like us (I assume every investment I make can fail) who are always looking over our shoulders.

Also, frauds are one thing, but the investing risks that catch people unawares are subtler. Often the promoter transforms a visible risk into a hidden risk, and the mark is none the wiser.

You remember my slightly tongue-in-cheek first law of investing?

“Investing risk cannot be created or destroyed. It can only be transformed from one form of risk into another.”1

And so Phil, Camilla, or Basey sees one risk, but ignores another:

• Scared of the risk of inflation, Phil invests in a higher-yielding offshore bond, not realizing it’s held in a different territory or that he can’t get his money out with less than 12 months notice.

• After reading about expensive markets, Camilla resolves to start investing in supposedly safer stocks like utilities for the steady dividend, but is oblivious to newspaper reports about tougher government regulation and politicians threatening re-nationalization.

• Terrified that High Street banks might go bust, Basey opens a peer-to-peer account and looks forward to a higher returns, but is surprised when struck by bad debts.

The fact is all investments are risky and can lose you money.

If you can’t identify the risk with an investment in advance, you shouldn’t go near it.

Types of investing risks

There really are innumerable ways for things to go wrong, so please see my bluffer’s guide to the main risks.

Then, next time you consider making an investment, think about which of these risks you’re taking, whether you’re comfortable with it – and whether there’s the potential for sufficient rewards to compensate.

Remember too that if something has an 95% chance of success, it wasn’t necessarily a scam if it fails. You could have just been in the unlucky 5% of dice rollers.

Risky business

The presence of risk does not mean an investment is a bad one. All investments have at least some risk.

What matters is whether price is right for the risk you’re taking, whether you can afford to take that risk, and whether you understand what you’re getting into.

As the great investor Charlie Munger says:

“Tell me where I’m going to die, so I won’t go there.”

Let’s be careful out there.

1. I’m convinced I was first to coin this as a play on the law of thermodynamics, incidentally. I have recently seen it credited to someone else on the web who first used it long after me. Anyway, I am not ripping them off and I assume them not me. Great minds and all that! 🙂 [↩]

What caught my eye this week.

I answer comments on old posts every day on Monevator. A great many ask whether investors should still own bonds, given rates are “sure” to rise – and hence bond prices fall.

In the UK it’s still mostly an academic question. But US yields have been going up fairly swiftly. The Federal Reserve has been raising interest rates, and there are more signs of higher inflation in the US, too. Bond prices have fallen as a result.

My reply is usually some mix of the following:

• Your bonds are there to cushion big share price falls, not to provide a huge return in themselves.

• Bond prices don’t really crash like equities do.

• People have been predicting a bond bear market since 2009 (and in truth before that).

• There’s no denying a sudden surge in yields would hit bond prices hard.

• But inflation (and hence lower real returns) is what really kills you as a long-term bond investor.

• A moderate correction that sent bond prices lower and yields higher would be good for long-term investors.

That last point is the hardest for people to accept. We’re so conditioned to obsess over the level of the stock market, for example, it’s easy to miss the importance of reinvesting and compounding returns. The same is true with bonds.

This week Sellwood Consulting wrote a very clear post explaining why bond investors shouldn’t fear rising rates. It is about US bonds, but the same logic holds true in the UK.

If you own bonds and yields rise, the value of your bond holdings will indeed fall. But thereafter you can look forward to a higher yield, and over time reinvesting this in now cheaper bonds can be more valuable.

Don’t hold too much in bonds, though. Not because they are super-risky – but because they’re not!

If you’re a long-term investor, being overly cautious can see you miss out on much higher returns. Michael Batnick explains why in his Irrelevant Investor blog this week.

Happy reading!

[continue reading…]

There’s not much else in investing that’s like gold. Companies listed on the stock market come and go. Currencies come and go. Heck, countries come and go!

But you’ll find gold in the Bible, and even before that.

I suppose it’s possible that in the year 4018 we’ll still be comparing this Vanguard tracker fund to that iShares version. But don’t hold your breath.

Of course, presuming scientific progress continues apace we’ll probably be able to make all the gold we want by then in our own 3D printing machines, as easily as making toast today.

This may put a distant Best Before date on two of the great virtues of gold – its relative scarcity and its peerless immutability – for anyone looking to invest over the next few centuries.1

On the other hand, alchemists have been trying to turn mundane matter into gold for millennia, and they didn’t get very far.

Had they succeeded they presumably would have crashed the gold price anyway – in the same way rampaging conquistadors in the Age of Discovery caused spiraling inflation in Spain when they sent back ships full of silver.

I told you these metals had history.

Gold: The barbarous relic

If this topic already strikes you as absurd in a discussion about modern investing, you’re not alone. Many investors hate the very idea of gold.

People have been digging up, fighting over, and reburying gold at vast expense for thousands of years. In that time it has done little for us save fill a few teeth, adorn the toilet seats of oligarchs and a certain US president, and play a modest role in electronics.

Yet gold continues to be coveted. And that alone is what gives it its great value.

Owning gold earns you no income. Shares pay dividends – or at least the promise of future dividends – and property and bonds pay an income, too. Even cash in the bank earns you some interest.

But gold pays zilch. If you buy one ounce of gold today and keep hold of it, in 100 years you’ll still have one ounce of gold. Gold doesn’t grow like a fruit tree or send you cheques in the mail. It just sits there. Looking shiny.

Worse, gold costs you money to keep it.

Because gold is expensive and easily transported – another of its benefits, actually, especially in a Mad Max societal breakdown scenario – it’s easily stolen.

This means gold must be kept under lock and key. And that costs money.

We can break down the cost of owning gold into two components:

• The direct cost of owning gold (fees to buy and hold, insurance, retaining your own gang of armed thugs et cetera)

• The opportunity cost of owning gold instead of cash (that is, the income you forego by having your money in gold instead of cash or bonds)

All assets come with these costs to varying degrees. With gold they loom larger.

Gold fingered

Another thing to remember is almost all the gold ever extracted is still out there somewhere.

Gold isn’t a commodity like oil or wheat that’s consumed. Its resistance to decay means gold stocks are always increasing, albeit slowly and with some lost in rotting hulks beneath the waves or forgotten under mattresses.

• When the price is high, gold comes out of the woodwork, as ordinary people cash in the gold trinkets or jewelry they have around the house.

• When the gold price falls, people forget about it. (And gold enthusiasts blame a global conspiracy.)

Gold price advances and declines can run for decades, with little apparent rhyme or reason.

The following chart shows the gold price in dollars2 over the past 100 years (in log format, which is the best way to view long-term charts):

Source: Macro Trends.

That looks great, but remember two things. Firstly 100 years is very long time. Secondly, inflation eroded the value of a dollar over that time.

Here’s the same chart showing real returns (that is, adjusted for inflation by deflating using the US consumer price index):

Source: Macro Trends.

We can see that gold has broadly kept – and even slightly grown – its value over the past 100 years after adjusting for inflation. But the ride has been very rocky, and there have been many periods where you lost money in real terms in gold.

How enthusiastically the typical investor will talk about owning gold probably depends on where they bought (and perhaps sold) on this timeline.

You might retort that the FTSE 100 index of shares didn’t make much progress following its year 2000 peak, say. The index was still underwater 15 years later.

True, but remember you would also have received regular dividends from your stake in the FTSE 100. Had you reinvested that income back into the index over time, you were up nearly 70% on your 1999 position by 2015.

In contrast, whether or not gold is in the doldrums you get paid nothing. In fact you pay to keep your dwindling pot of gold safe and secure.

Reasons to own gold

You may ask why anyone would own gold, given all these drawbacks? There’s a lot of stuff we used to do religiously that we don’t do anymore. Should hoarding gold go the way of other out-of-date wisdom, such that business about coveting your neighbors’ ass?

Views differ, to put it mildly. Respected passive investment writers such as Tim Hale and Lars Kroijer tell you to skip gold. Warren Buffett, the greatest active investor of all-time, also thinks gold is pointless.

But not everyone who invests in gold is a moony-eyed maniac longing for the return of the Aztec empire. These sober gold owners have three good reasons to hold gold:

Store of long-term value – Gold is often touted as retaining its worth against the ravages of inflation. Gold doesn’t pay an income, but over the long-term the price has risen and that’s preserved purchasing power. You will hear folksy anecdotes about an ounce of gold always being able to buy a decent tailored suit, for example. More rigorously, respected researchers such as those behind the Credit Suisse Global Yearbook3 have found that gold has on average been resistant to inflation in developed markets over the long-term. But beyond keeping its value, real4 returns have been small to non-existent, depending on your country, and there have been long periods where gold was underwater. Gold does not move in lockstep with inflation – not even when measured over years. Some people argue the price is so erratic it’s useless as a protector against inflation, since it cannot be relied upon.

Asset of last resort – Such gold skeptics would not include anyone unlucky enough to live in a period of hyperinflation for their economy. To a middle-class German in the 1930s – spending their wages in bundles of paper notes from a wheelbarrow before they become worthless – quibbling over a few percent of return might sound ludicrous. Similarly, German Jews couldn’t take much with them when they fled the Nazis, but gold could be hidden in a coat or shoe. Inflation-protected government bonds probably won’t cut the mustard at the end of the world, but the precious metal might still buy you safer passage. (Cynics say you need guns and baked beans (and a can opener) in that dire scenario.)

Gold is not very correlated with shares and bonds – I mentioned the gold price is erratic. It’s also, historically, shown little inclination to pay any attention to what other asset classes are doing. This almost makes gold the Holy Grail of investing – a non-correlated asset that can improve diversification and potentially cushion your portfolio – except for its very low expected returns. Your gold may or may not crash when your shares or bonds do, but it could equally well fall when the rest of your portfolio rises – and all without any great confidence of a good long-term real return. Still, you could get a rebalancing benefit from tinkering with your positions over time.

Source: GBI Gold / Bloomberg / Erste Group.

For most people who want to own some gold, these factors point towards it being an emergency or insurance asset, rather than a big holding. Having 3-5% in gold won’t do your long-term returns massive harm if you’re unlucky enough to own it through a long gold bear market – and it may come into its own in a crisis.

But as I say, views differ, and some investors own a lot of gold. One interesting low-volatility model allocation – the Permanent Portfolio – mandates a massive 25% holding in gold.

Also, true gold bugs (don’t call them that to their face) would argue even 100 years of return data is deceptive. They’d note all paper money (like our pounds and dollars) has eventually failed in the past – yet people still value gold today.

There’s no definitive answer. As I said, gold is strange like that.

Perhaps the best metric is how do you feel about it? If you’re drawn to gold and you’re happy to pay for it, then no doubt other people are, too. Buy a little.

If you’re repulsed by gold, don’t feel guilty about skipping it. You’ll do fine. Probably.

How to hold gold

Should you decide to you want to own some gold, you’ll need to decide how and where. Because another weird thing about gold is there’s a lot of choice.

Gold ETCs are the easiest way to get exposure to the gold price. ETCs (Exchange Traded Commodities) are just another kind of ETF. They are cheap to buy and the ongoing costs can be as low as 0.2% or so. That’s good value compared to what your grandparents would have paid to store gold in a bank vault, but it’s still a non-trivial drain if the gold price goes down or sideways for 20 years. Both synthetic and physical forms are available. Physical gold ETCs are backed by bullion. A synthetic ETC does not own any gold, just derivatives linked to the gold. (It may be cheaper, but if you want to ask a gold bug whether a synthetic ETC is the best way to get exposure to the benefits of gold – duck!)

Services like Bullion Vault5 and the Royal Mint bring you a step closer to physically owning gold. They have hoards of it in big safes. When you buy gold with them, a ledger records that you own a certain amount of that physical gold. Invest more and the ledger moves accordingly. Because the gold never leaves the bunker, it doesn’t have to be re-tested for purity, which saves money compared to taking physical ownership. But the services do stress this so so-called ‘allocated gold’ is still legally your personal property. Bullion Vault’s gold for example is held in vaults in various locations around the world, separate from the balance sheet of that company. If it goes bust, the gold should still be yours rather than, say, fair game for an administrator. Hold gold offshore and you may even have a back-up asset against shenanigans at home with your currency or your government if things turn nasty. Whether you’ll be able to access gold you stored in Zurich in the Zombie Apocalypse is debatable. (See an older article I wrote about Bullion Vault).

Physical gold bars, coins, and jewelry are the old-fashioned way to hold gold. In theory, pretty simple – buy something gold and keep it. In practice there are complications. You will have to bear the cost of holding, securing, and insuring your gold yourself. While it might be an acceptable risk to have a couple of gold coins hidden in your shed, beyond that it’s a security risk. Then there’s actually buying gold. You can’t just take somebody’s word the coin they’re selling is made of gold (for all I could tell it could be made of chocolate). This means every time gold changes hands it must be tested for purity (assayed), which costs money. Some forms of gold may also have value beyond the metal (notably jewelry) but do you have the expertise to assess that? On a more positive note, holding your own gold is the only way to go if you want it for when society breaks down. You’ll presumably need it to be accessible in a world without the Internet and scheduled flights. There can be tax advantages, too, if the coins you buy are UK currency – British gold sovereigns, for instance – so do your research.

Buying shares in gold miners gives you exposure to the gold price. However it also brings in a lot of other kinds of risk, such as management and market risk and exposure to other commodity prices (mining for gold uses vast amounts of energy). Gold miners are cyclical, and most people will do poorly trying to trade them. You could consider buying a specialist fund that invests in gold miners, but this is active investing and so you almost certainly shouldn’t.

Taxes are a whole other area to consider. Gold and taxes is an article in itself. In short gold ETCs can be held in ISAs and SIPPs and ideally you’ll want to do so, to avoid capital gains taxes on any gains when you sell. Gold platforms may enable you to wrap your gold in a SIPP, but as far as I know not in ISAs. As I say, some gold coins are capital gains tax free, but coins cost you more to buy and sell, so don’t think you’re going to day trade gold sovereigns.

Probably the best thing to do if you want some exposure to gold is to buy it, hold it, and do your best to nearly forget about. You might only need it in an emergency. Sort of like when you buy travel insurance.

If it never pays you to have bought gold, then you probably lived through happy times. Who cares then if your gold did nothing?

1. Improving man-made competition is already a good reason to avoid plain diamonds as a store of value, in my view. [↩]
2. Like most commodities, gold is invariably priced in dollars. [↩]
3. See the 2012 edition. [↩]
4. i.e. Inflation-adjusted. [↩]
5. Affiliate link. [↩]