Gold and silver have always been and will always be many investors' favorite precious metals. The summer sell-off and subsequent bounce in gold and silver has reignited investment fever in the commodities.
Traders often substitute silver for gold because the two have a strong correlation with each other. However, the commodities are very different and should not be used interchangeably despite the seeming correlation.
Trading commodity futures is difficult. This is true even if you are on the inside. There is no such thing as illegal insider information in the commodity markets. Acting on information that would result in a lengthy prison sentence in the stock market is common -- and considered an edge -- in the commodity markets.
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A firm might have many millions in capital combined with near perfect information on supply, demand and supply chain logistics, and it might even own large stores of a commodity, but it is not guaranteed success in the volatile commodity futures market.
I have direct experience with this. Several years ago, our hedge fund advisory firm was fortunate enough to obtain capacity rights to a hedge fund that was the world's largest trader of a particular metal commodity. (Many top hedge funds are closed to new investments and permit only those firms with relationship-driven capacity rights to invest.)
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This particular fund had an incredible track record -- it was up more than 100% during the year before our investment -- and was led by a trader who is widely thought to be among the best in that niche. My firm makes money only when our investors make money, so as soon as the capital was deployed, I was counting my small percentage of profits as virtually in the bank, based on the reputation and track record of this fund.
It employed sophisticated hedging and correlation strategies that supposedly locked in profits. These tactics combined with the physical market knowledge created a very compelling investment.
As fate would have it, soon after we invested, the fund inexplicably plunged in value -- the first time in the fund's history that it had lost money. What an incredible letdown!
However, this situation helped cement the fact that the past does not equal the future in the financial markets. In addition, I learned that there are many "old wives' tales" in the financial markets. One of these is that the big guys always make money. Even large funds, led by world-renowned experts, can and do lose money.
Secondly, commodities that appear to be correlated don't provide the same opportunities for investors. Specifically, correlation on a price chart doesn't necessarily mean one metal can be substituted for the other in an investment account. The primary reason is that each commodity is moved by different price drivers.
Price drivers are the underlying factors that affect the price of a financial instrument. Obviously, supply and demand are the primary price drivers of any stock or commodity. Price drivers break the economic theory of supply and demand into actionable parts.
The price drivers for gold and silver are very different. Gold is primarily used for jewelry and investment purposes. On the other hand, close to half of all demand for silver is from industrial sources. This means that demand for silver is tied more tightly than gold to industrial growth.
At the same time, gold demand is more closely tied to jewelry demand and macroeconomic factors like inflation and central bank actions. Unlike silver, gold is considered a store of value and is used by central banks on a grand scale for this purpose.
Supply is also very different. Both silver and gold are mined directly, but silver can be a by-product of gold refining and industrial processes.
This chart shows the ratio of the number of ounces of silver required to purchase 1 ounce of gold over the past decade.
Interestingly, there is more gold than silver aboveground. An estimated 5 billion ounces of gold have been mined, compared with 450 million ounces of silver. Despite the vast supply differences, gold is substantially more expensive than silver. Clearly, this isn't based on supply but rather demand. The perceptions of gold as an alternative currency and investment hedge push its value far beyond that of silver.
Risks to Consider: As described earlier, precious metal investing can be extremely risky even for proven experts. This is particularly true for short-term trading. As in all investing, be certain to diversify.
Action to Take --> Despite the correlation, silver and gold are two different commodities with different underlying price drivers. Due to its lower price, silver can exhibit greater volatility than gold. Based on this, silver is a superior short-term trading vehicle, whereas gold makes more sense for the long term. A balanced portfolio will contain both gold and silver in a ratio best suited for the individual's goals.
-- David Goodboy
P.S. -- StreetAuthority's Dave Forest recently identified a gold miner that's selling for dirt-cheap prices compared to the price of gold -- especially when you consider that it's one of the top low-cost producers in the sector. Out of fairness to his Scarcity & Real Wealth subscribers, we can't reveal the name of the company here, but you can get access to his September issue and learn the name of this company by signing up for a risk-free trial Scarcity & Real Wealth. To get all the details, click here.
David Goodboy does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC does not hold positions in any securities mentioned in this article.