Often the greatest risks inherent in any asset is our own lack of understanding of how to properly manage it and how much of any one asset you should own
Bullion.Directory precious metals analysis 21 November, 2014
By Terry Kinder
Investor, Technical Analyst
We have met the enemy and he is us.
I have been doing a lot of thinking about investing lately – whether Bitcoins, physical gold or silver, ETFs, or gold mining stocks. There, of course, is a great diversity of opinion within the gold community whether or not you should hold any type of paper assets outside of the absolutely necessary to survive.
It is a fascinating debate, but we’re not going to delve into that in anything but a superficial manner here. Instead, we’re going to get to the heart of the matter when investing in gold mining stocks or anything else – risk
Risk: Thinking about it can give you a headache, but it must be done.
Risk is everywhere. Even assets like gold and silver present a certain amount of risk.
For example, let’s say Lucky Johnson decided to allocate 80% of his net worth to gold right at the peak gold price of $1,921.00. Lucky backed up the proverbial truck and loaded it chock full of gold right at the high. We’re not here to debate the inflation-adjusted price of gold, just to consider the risk our friend Lucky has taken on.
Lucky owns an almond farm in California that he purchased as an investment, hoping to make the operation more efficient and profitable and then turn around and sell it for a profit. Unfortunately, for Lucky, California is in the middle of a drought, so his water expense has skyrocketed. He can’t stop watering the almond trees because they will die without water and, without the trees, he will take a giant loss selling the farm.
Lucky needs some extra capital to upgrade the irrigation for his almond farm, but the greater part of his wealth is tied up in gold which has declined in value from over $1,900.00 per ounce to around $1,200.00. Now, we can discuss precious metals manipulation all day long or how the financial system is such a mess, but it doesn’t do Lucky any good.
He needs money to upgrade his irrigation system. He tries to get a bank loan but there isn’t any bank willing to take the risk to loan money to an almond farmer in the middle of a drought. So, Lucky is forced to sell all of his gold and then raises the remaining money to keep the farm afloat through friends, family and a few business associates. Disaster is avoided, for now, but Luck’s net worth has taken a huge hit. If the drought gets much worse, Lucky will likely end up losing everything.
So, what was Lucky’s mistake? Was it buying gold? Was it buying an almond farm, or was it something else?
Lucky’s mistake, in a nutshell, was not properly assessing his risk and properly allocating his scarce resources in light of that risk. Lucky had monumentally bad timing buying gold at over $1,900.00 per ounce, but that wasn’t his biggest mistake. His biggest mistake was that he didn’t properly weigh the risk of allocating such a large percentage of his net worth to just one asset – gold.
Gold may not have any counter-party risk per se, but choosing to purchase anything represents a decision to not purchase something else.
Saving represents a decision to forego buying the latest tech gadget. Going on an expensive vacation means you may not put enough money in your “rainy day” fund. Every decision we make to buy or sell, spend or save, choose one career or another, work for ourselves or for someone else, involves risk. Lucky put too large a portion of his wealth in a single asset and did not consider either the risk that the price of gold could drop or that he might one day need additional cash for his business.
You don’t automatically escape risk through purchasing gold. Nor do you necessarily take on undue risk by purchasing gold mining stocks if you consider your overall asset allocation to them relative to your net worth, and if you use proper position sizing when buying individual stocks.
Risk is everywhere.
Whenever someone tells you some asset is completely safe, you should run, not walk, in the opposite direction from that person. One of the greatest risks in any asset is our own lack of understanding of how to properly manage it and how much of any one asset you should own.
Whether you are an investor, a gold stacker, an employee, a businessperson, etc. you must weigh the risk involved in the financial decisions you make. You may be able to avoid thinking about risk, but ignoring risk won’t make it go away.
Additional Resources Related to Risk:
1. Harry Browne’s Permanent Portfolio
2. Van Tharp (Video): Money Management With R Multiples
3. Van Tharp (Video): Position Sizing Strategies: Control Your Risk When Trading
Special Thanks:
Josh Javrin of WealthQuant for getting me to think more about ‘R’ or risk and for pointing me towards the work of Van Tharp.
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Excellent article, Terry. It’s true, contemplating risk management can give us a headache. But it saves so many down the road. Thanks for the mention!