Now and then we hear stories of someone who went all in on a particular investment and made handsome profits. Does this mean that diversification is for idiots? Billionaire Mark Cuban once said diversification is for idiots, suggesting that making concentrated bets is a better strategy than diversification. Lets take a closer look at diversification and how it may be achieved within precious metals investments.

Why diversify your investments?

The main reason for diversification is to avoid having all your eggs in one basket. Although we hear stories where highly concentrated bets have paid off, there are plenty of stories where it has ended very badly. That’s the problem, lack of diversification results in extreme outcomes in either direction. The aim of diversification is to balance the risk and reward. In an arena where there are no certainties, only probabilities, diversification seems a reasonable strategy.

Types of gold and silver investment

When we talk about investing in precious metals, there are multiple types of investments within this asset class.

  • Physical bullion
  • Numismatics
  • ETF’s, mutual funds
  • Options, futures
  • Mining stocks

Some may argue that these investments are all strongly correlated to the spot price of gold, implying that there is limited scope for diversification. However, when it comes to diversification price is not the only issue under consideration. Diversification comes in many forms.

Diversification of risk

Not all investments have the same level of risk. Within precious metals investments, physical bullion has the lowest risk. Mining stocks and futures contracts carry higher risks, but also have a greater potential for rewards

Level of risk (lowest to highest)

  • Physical bullion
  • ETFs
  • Mining stocks
  • Options, futures

Diverse forms of leverage

Investors looking for highest potential returns will be using leverage which can come in diverse forms.

  • Loan to buy physical bullion
  • ETF’s on margin
  • Leveraged ETFs/ETNs
  • Options/CFDs/Futures
  • Mining stocks
  • Private placements

For more details, see the previous post covering leveraged precious metals investments.

Investment taxation and fees

Different forms of gold and silver investment may be associated with differences in taxation and fees. For example, at the time of writing, British gold bullion coins considered to be legal tender are exempt from capital gains tax in UK. However, gold bullion bars are liable for capital gains tax.

This doesn’t necessarily mean you should put all of your allocation in an vehicle with the lowest taxes because tax rules can change at any time. It is important to check, and keep up to date with the current taxation rules in your location.

Risks of physical vs paper gold and silver investments

Diversification may also be in the form of paper and physical products. Each is associated with different risks. The obvious risk with physical bullion is theft or confiscation. When buying physical gold bullion, it is also possible to get ripped off with fake gold-plated tungsten coins or bars.

Paper gold investment products may carry the risk of broker or custodian bankruptcy. Some digital gold or silver products might be susceptible to hacking. There have also been examples of gold mining scams such as the Bre-X scandal. Another possibility is ETF fraud, where the fund does not hold the physical gold or silver they say they do.

Diversification of investment location

Diversification may be achieved in terms of location of investment. Physical bullion might be kept partly in the home to be readily at hand in an emergency. Some may be kept in a professional non-bank vault. Those investing large amounts may diversify by using multiple vaults within a city or multiple vaults across multiple cities. Some may store gold in multiple countries as a way to diversify against political risk. Owning mining stocks with mines in different locations around the world also provides diversity for those who may be concerned about mine nationalization risk.

Diversification of physical gold and silver

Physical gold can be purchased in a variety of forms. Coins which are preferred for liquidity. Numismatic coins can be used to diversify against confiscation risk. Large gold and silver bars tend to be purchased by investors to minimize premiums. The advantage of high purity gold and silver jewelry is that it can be freely transported across borders, whereas coins and bars tend to attract attention, potential taxation, and require forms to be filled at the border. Some therefore allocate some of their investments into gold bullion jewelry.

Diversification of mining stock risk

The risk profile of mining stocks vary. Major gold producers tend to carry a lower risk than junior gold miners, which in turn carry a lower risk than gold explorers. Silver mining stocks tend to to more volatile than gold mining stocks. This variety makes it possible to diversify your mining stock portfolio risk to some extent.

Diversification of investment time horizons

Investments within the gold space can also be diversified in terms of time horizons. You might apportion part of your investment into physical gold with the intention of holding it for life and passing it on to the next generation. Some might be in a retirement fund for you to access in a decade or two. You might hold some mining stocks for a couple of years. The leveraged part of your portfolio might only be held for days or weeks.

Conclusion

There are many ways to consider diversification within gold and silver as an asset class, and this way of thinking can be extrapolated to other asset classes, and indeed to your whole portfolio. There is no “one-size-fits-all” answer regarding portfolio allocation because people will naturally differ in terms of their beliefs and risk tolerances. Such factors have to be taken to account when determining the level of diversification that is right for you. Diversification is not for idiots, diversification is important for investors who want to manage their risk in a way that suits their individual situation.