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Monday, September 7, 2009

General Commentary: Collectibles vs. Precious Metals as Investments

Every day, millions of TV viewers are bombarded by commercials touting precious metals, especially gold, as a prudent investment and hedge against inflation. These commercials frequently feature prominent elderly actors who convey a sense of dignity and wisdom as they exhibit their lustrous gold bars and coins. Certainly, the three precious metals which are most widely recommended for investment - gold, silver, and platinum- are beautiful, and serve not merely as coins and jewelry but have many other uses in industry.

Unfortunately, over the very long-term, precious metals have proven to be terrible investments. By very long-term, I mean the last 1,000 years, which may seem an insanely long view to take, but is necessary in order to see how new discoveries and progress in mining and refining technologies have affected value.

The basic problem with all three metals is two-fold. First, they are all extremely common on Earth, but are valuable because the current cost of extraction is still high. Gold, for instance, exists in different levels of concentration all over the earth, and is present in seawater at levels of around 50-70 ounces per cubic mile, although the current cost of refining it from seawater is over $5,000 per ounce. The second problem is that both gold and platinum are not consumed or otherwise lost when used (gold-mainly in electronics/computers and dentistry, platinum- in electronics, catalytic converters, and lab equipment), but are recoverable, so there's little diminution of supply. Silver is less recoverable, but is extremely common.

The buying power of both gold and silver have declined dramatically over the very long term. In the Middle Ages through the Renaissance, the buying power of gold (inflation-adjusted) ranged from about $ 1,200 to $ 2,400 per ounce. Interestingly, for much of that period, silver's value was about a third of gold's. New discoveries, in the Americas, Africa, and eventually, Australia and New Zealand, and new methods of mining and refining, created a relative glut in supply and forced prices downward.

I expect this trend to continue, although I am certainly not ruling out dramatic spikes in price over the next 10 or 20 years. The drawback to looking at very long term trends is that generally, they're only relevant to the very long term. This may be somewhat less true in this instance, however, because the rate of technological progress has accelerated greatly over the last 50 years. A historical precedent exists: before Charles Martin Hall's invention of an efficient means of refining aluminum in 1886, it was more valuable than gold. Bars of aluminum were exhibited alongside the French crown jewels at the Exposition Universelle of 1855. It's not very difficult to imagine how aluminum speculators felt after the big collapse.

I view investing in precious metals as similar to walking into a casino and "betting against the house" - the house being the long-term trend. One can bet odd or even at the roulette wheel, double the bet at every loss, and seem to make money in the short-term, as long as there isn't a run of losses which wipe out the bettor. Similarly, if a new discovery or the invention of a new extraction process creates an oversupply of gold, children will be pleased to discover a little gold toy in every box of Cracker Jacks.

When contrasting precious metals with collectibles in general, the main factor which comes into play is, again, supply. The question of demand must be considered on an individual basis, and concerns demographic and cultural factors relating to each type of collectible. Certainly, demand for a particular category of collectible can diminish almost completely- an example of this is the near-death of cigar-band collecting, which was one of the most popular hobbies in the U.S. around 1900. It is very important for a collector-investor to attempt to gauge long-term trends in demand for the whole collectible category in which he is involved- not merely a few collectibles within it.

Given that caveat, within a growing market for a particular collectible category, the primary advantage of investing in the collectibles within it that have the best prospects for growth is that supply is either static or diminishing. This is especially true of fragile collectibles such as stamps, which require that the collector pay some attention to preservation in order to avoid their being destroyed or their condition degraded. Paradoxically, with stamps, the most valuable items are usually preserved the best, while the more common, inexpensive stamps are destroyed at a much faster rate, and therefore often appreciate more over the long term.

The oft-cited major disadvantage to collectibles investing is that it requires a specialized knowledge of the collectible area in which the investor wishes to concentrate, but I would argue that it is always advisable to have as much knowledge as possible about anything in which a person wishes to invest before jumping in. Frequently, investors who pursue the more popular, conventional investments, such as stocks and precious metals, ignore the need for research and analysis, and many an investor will spend more time researching a new appliance that he's considering purchasing than a major investment in a stock.

Many precious metals dealers advise their clients to allocate 5%-10% of their portfolios to investments in gold or other precious metals. I conclude by proposing that investing 5%-10% in an established collectible category in which a collector-investor has built a substantial knowledge base, and which he follows more closely because he is a hobbyist as well as an investor, makes a lot more sense.

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