Gold or Silver: Which mindset are you?

Precious metals are likely the most polarized of all assets. Opinions often swing between gold and silver having no economic utility to being virtually hallowed. Others see precious metals as offering profitable short-horizon trading opportunities.   

Here is a quick thought experiment. Imagine for a moment, that you wake up in any country in the world, and more dramatically, at any time in the past or future. Alone, confused, and shaken, would you rather have in your possession – gold and silver coins, US Dollars, a cryptocurrency of your choice, or a four-meter-wide Rai stone from the Yap Islands.

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Most people would likely settle on gold and silver. History shows that precious metals are able to transcend the in-vogue definition of economic value, regardless of societal attitudes or generational preferences. Something deep in our evolutionary consciousness seems to draw us to their enduring luster. Gerald M. Loeb, the legendary trader once proclaimed, “The desire for gold is the most universal and deeply rooted commercial instinct of the human race.”

It is for this reason that gold and silver are both tightly enmeshed with monetary history. As recently as 1971, the Dollar derived its credibility from gold. That is until, as Professor Harold James of Princeton’s Department of History said, “President Nixon severed the millennia-long link between money and precious metals”.  

Unlike financial assets and even fiat currency, which are derived purely from human imagination, precious metals’ claim to stability is drawn from the very fact that they are relatively resistant to such forces. Due to this, both gold and silver offer long-term hedges against market volatility.

By being largely outside the financialized system, physical precious metals can’t simply be “created”. Even reserve currencies, the latest of which is the US Dollar have proven to be creatures of a time and place, destined to become part of a long line of glorious ancestors. By extension, financial assets suffer from the same finiteness.

As an investor, precious metals may not appeal to your appetites or horizons, but they have been able to maintain value throughout the eras. In short, precious metals are a store of value, and that is the key benefit they offer. William McFee, the British-American author famously wrote, “It is extraordinary how many emotional storms one may weather in safety if one is ballasted with ever so little gold.”

The evaporation of fiat currencies may seem like an extreme scenario, but even the iconic Charlie Munger stated as recently as February, “(I) think the safe assumption for an investor is that over the next hundred years, the currency is going to zero.”

Despite the dollar’s dominance, monetary transition appears to be upon us. CBDCs are at the top of the agenda for most central banks, inflation is at historic highs, war and shortages have taken center stage, and yields have risen sharply amid murmurs of challenger currency blocs and bilateral swap lines.

Gold and silver are highly liquid, universally accepted, can’t go to zero, and secure from hacking. In addition, they do not suffer counterparty risk, i.e., the risk that another party will not fulfill their financial obligations, such as for bond payments or equity put options.

The price of gold and silver is not the price of gold and silver

The prices of gold and silver that we are so used to seeing are the prices of paper gold or paper silver. These are essentially derivatives, that are meant to represent physical gold or silver. These ‘representations’ are many thousands of times larger than the precious metals held by exchanges. In a 2013 publication, the LBMA confirmed that physical metals do not change hands in 95% of trades. The bottom line is that traders are not exchanging actual metals, and buying and selling is largely disconnected from the physical asset.

As a result of its magnitude, the paper market is the price maker while the physical market is a price-taker.  Some may be inclined to call this a classic case of the tail wagging the dog. Each physical dealer and coin shop provides an independent rate depending on manufacturing and transportation premiums, taxation, and overheads.

Thus, much of the reported volatility in the price of precious metals is a result of volatility in paper trading, and not in the underlying assets.

Silver

For young investors with limited capital, the affordability of silver is a good option. It costs a fraction of gold (1/84th by today’s prevailing international prices). It is also possible to store silver in smaller denominations, giving the freedom to save and liquidate smaller monetary volumes, especially during inflation or global monetary crises.

According to the CPM Group, the silver market cap was approximately one-twelfth the size of the gold market in 2019.  In the long-run, silver and gold share similar boom and bust cycles. However, due to its small size (less than 1% of the value of Apple Inc today), silver is susceptible to relatively small movements in the financial markets. According to the Royal Mint, it “can increase or decrease by 20% or more in a short period of time”.

A silver investor would need the risk appetite to endure sharp swings in the short run. Conversely, the fluctuations in price can result in a strong upside and offers the opportunity for high returns.

In some senses, silver falls between equities and gold, by being a physical asset it provides store-of-value functions, while its fluctuation provides growth opportunities.

However, discretion may be the better part of valor, with trading best left to professional metal traders.  

A key distinction between gold and silver is in their industrial usage. Due to its electrical and thermal conductivity, silver has applications in batteries, solar panels, precise scientific equipment, medical treatments, and wearables. More than half the demand for silver is from such industrial sources. As a result, the metal is much more in-sync with technological innovation and economic growth cycles.

Interestingly, data suggests that when the metal loses out on industrial demand during downturns, it reverts to a more gold-like, capital preservation mode. Thus, silver balances both speculative and insurance aspects.

One big drawback of silver is storage. This can be difficult or even impractical, due to the low denomination value of the metal. As per Goldsilver.com, $5,000 in silver holdings, would require an entire shoebox. Alternatives include a bank vault or a private security company, both of which would charge additional fees. Taxation and insurance are other important considerations that vary by jurisdiction.

Unique Opportunities

With a monetary transition in the offing, if demand for silver rises among central banks in the coming months or years, prices would likely surge.

Since recycling is not sustainable, millions of ounces of silver are lost each year to industrial processes. Any supply chain disruptions could result in capital accumulation opportunities.

Gold

The Italian-English writer, Rafael Sabatini, famously remarked, “Gold has at all times been considered the best of testimonies of good faith”. Even today, in a post-gold standard world, central banks continue to maintain vast reserves. According to the journalist James Surowiecki, governments hold on to gold “as a kind of magic symbol, a way of reassuring people that their money is real.”

Gold prices tend to be far more stable than those of silver, due to a larger market cap as well as a much lower industrial demand (generally around 8%). Moreover, above-ground stocks continue to grow steadily, unlike silver.

Gold investments usually suit investors with larger capital to diversify against macroeconomic headwinds. For smaller investors, purchasing a significant amount of gold may be difficult, while smaller denominations incur higher premiums.

Crucially and contrary to popular sentiment, the yellow metal has exhibited its insurance properties during both inflation and deflation.

Although it is most often thought of as an inflation hedge, the LBMA states that there “is a clear logic” to owning gold in deflationary periods. As the global economy slows, sharp monetary stimulus is injected, which pushes up the demand for hard assets. Well-known market commentator Jim Rickards shares this view, saying, “It doesn’t matter if gold falls if overall prices fall further – so gold is precious, even under deflation.”

Like silver, gold would require storage, but takes up significantly less space and doesn’t corrode.

Physical gold may also present opportunities for wealth creation during monetary transitions or severe economic headwinds.

Can I blend both into my portfolio?

A rough guideline may be to hold 10% of your assets in physical precious metals, in the ratio of 10:1 in favour of gold.

A blend of gold and silver that provides growth opportunities and long-term hedging, would depend on affordability, individual risk appetites, the state of commodity markets, and your financial goals. A popular way to gauge when to buy or sell precious metals is the gold-to-silver ratio, which we will discuss in a future article.    

Growth rates of gold and silver tend to move in tandem. Silver’s volatility and industrial applications mean that although it follows gold, it tends to rise higher and fall further. Taking 5-year growth rates from 1968 to 2022, we can see the hedging effect of precious metals against movements in the S&P 500. 

With accelerated interest rate hikes expected, potential monetary transition, and high levels of market uncertainty, both metals can contribute to your portfolio in distinct ways to diversify risks and provide greater stability.

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