A Beginner's Guide to Precious Metals

Gold and silver have been recognized as valuable metals, and have been coveted for a long time. Even today, precious metals have their place in a savvy investor's portfolio. But which precious metal is best for investment purposes? And why are they so volatile?

There are many ways to buy into precious metals like gold, silver, and platinum, and a host of good reasons why you should give in to the treasure hunt. So if you're just getting started out in precious metals, read on to learn more about how they work and how you can invest in them.

We'll start with the grand-daddy of them all: gold. Gold is unique for its durability (it doesn't rust or corrode), malleability, and its ability to conduct both heat and electricity. It has some industrial applications in dentistry and electronics, but we know it principally as a base for jewelry and as a form of currency.

The value of gold is determined by the market 24 hours a day, seven days a week. Gold trades predominantly as a function of sentiment—its price is less affected by the laws of supply and demand. This is because new mine supply is vastly outweighed by the sheer size of above-ground, hoarded gold. To put it simply, when hoarders feel like selling, the price drops. When they want to buy, new supply is quickly absorbed and the gold prices are driven higher.

Several factors account for an increased desire to hoard the shiny yellow metal:

1. Systemic financial concerns: When banks and money are perceived as unstable and/or political stability is questionable, gold has often been sought out as a safe store of value. 
2. Inflation: When real rates of return in the equity, bond or real estate markets are negative, people regularly flock to gold as an asset that will maintain its value. 
3. War or political crises: War and political upheaval have always sent people into a gold-hoarding mode. An entire lifetime's worth of savings can be made portable and stored until it needs to be traded for foodstuffs, shelter or safe passage to a less dangerous destination. 

Unlike gold, the price of silver swings between its perceived role as a store of value and its role as an industrial metal. For this reason, price fluctuations in the silver market are more volatile than gold.

So, while silver will trade roughly in line with gold as an item to be hoarded (investment demand), the industrial supply/demand equation for the metal exerts an equally strong influence on its price. That equation has always fluctuated with new innovations, including:

1. Silver's once predominant role in the photography industry—silver-based photographic film—which has been eclipsed by the advent of the digital camera.
2. The rise of a vast middle class in the emerging market economies of the East, which created an explosive demand for electrical appliances, medical products, and other industrial items that require silver inputs. From bearings to electrical connections, silver's properties made it a desired commodity.
3. Silver's use in batteries, superconductor applications, and microcircuit markets.

It's unclear whether, or to what extent, these developments will affect overall non-investment demand for silver. One fact remains: Silver's price is affected by its applications and is not just used in fashion or as a store of value. 

Like gold and silver, platinum is traded around the clock on global commodities markets. It tends to fetch a higher price than gold during routine periods of market and political stability simply because it's much rarer. Far less of the metal is actually pulled from the ground annually.

There are also other factors that determine platinum's price:

1. Like silver, platinum is considered an industrial metal. The greatest demand for platinum comes from automotive catalysts, which are used to reduce the harmfulness of emissions. After this, jewelry accounts for the majority of demand. Petroleum and chemical refining catalysts and the computer industry use up the rest.
2. Because of the auto industry's heavy reliance on the metal, platinum prices are determined in large part by auto sales and production numbers. "Clean air" legislation could require automakers to install more catalytic converters, raising demand. But in 2009, American and Japanese car makers started turning to recycled auto catalysts or using more of platinum's reliable—and usually less expensive—sister group metal, palladium.
3. Platinum mines are heavily concentrated in only two countries—South Africa and Russia. This creates greater potential for cartel-like action that would support or even artificially raise platinum prices.

Investors should consider that all of these factors serve to make platinum the most volatile of the precious metals.

Let's take a look at the options available to those who want to invest in precious metals.

1. Commodity ETFs: Exchange traded funds exist for all three precious metals. ETFs are a convenient and liquid means of purchasing and selling gold, silver or platinum. Investing in ETFs, though, doesn't give you access to the physical commodity, so you don't have a claim on the metal in the fund. You will not get actual delivery of a gold bar or silver coin.
2. Common stocks and mutual funds: Shares of precious metals miners are leveraged to price movements in the precious metals. Unless you're aware of how mining stocks are valued, it may be wiser to stick to funds with managers with solid performance records. 
3. Futures and options: The futures and options markets offer liquidity and leverage to investors who want to make big bets on metals. The greatest potential profits and losses can be had with derivative products. 
4. Bullion: Coins and bars are strictly for those who have a place to put them like a safety deposit box or safe. Certainly, for those who are expecting the worst, bullion is the only option, but for investors with a time horizon, bullion is illiquid and downright bothersome to hold.

Precious metals offer unique inflationary protection—they have intrinsic value, they carry no credit risk, and they cannot be inflated. That means you can't print more of them. They also offer genuine "upheaval insurance" against financial or political/military upheavals.

From an investment theory standpoint, precious metals also provide low or negative correlation to other asset classes like stocks and bonds. This means even a small percentage of precious metals in a portfolio will reduce both volatility and risk.

Every investment comes with its own set of risks. Although they may come with a certain degree of security, there is always some risk that comes with investing in precious metals. Prices for metals can drop during times of economic certainty, putting a damper for people who like to invest heavily in the precious metals market. Selling may be a challenge during times of economic volatility, as prices tend to shoot up. Finding a buyer for physical metals may be difficult.

Another risk to precious metals prices includes the issue of supply. When demand shoots up, the existing supply may begin to deplete. And that means producers will have to bring more of each metal into the market. If there is a short supply of mineable metals, that could put pressure on prices.

Precious metals provide a useful and effective means of diversifying a portfolio. The trick to achieving success with them is to know your goals and risk profile before jumping in. The volatility of precious metals can be harnessed to accumulate wealth. Left unchecked, it can also lead to ruin.