How to Invest, Not Speculate!

A few days ago, the Government of Cyprus announced that it would gradually sell their gold reserves worth 400 million Euros, as a part of the actions to rescue the country's economy. And whether it had correlations or not, a few moments later the price of gold on the New York Futures Market plunged to as low as of US$ 1,351 per oz. If calculated from the peak position of US$ 1,908 in August 2011, the gold price had fallen 29.2%. Well, if viewed from the perception that the Jakarta Composite Index (JCI) will typically drop by 20 - 25% from the peak (when the bear period occurred), then it is the gold that experience its ‘bear period’.

After the drop of the gold price, various parties including large institutions like J.P. Morgan then tried to explain the cause of the fluctuations, but we will not discuss it because after I read it carefully, the analysis tends to be inconsequential (or perhaps it was too sophisticated so an amateur like me just cannot understand? But whatever, I don't invest in gold anyway). Here we will try to study this case from the beginning. Okay, let's start!

Gold had always been known as a hedging instrument, ie an instrument to protect the value of assets due to inflation and others. If you have some idle cash and not know where to put it, because the bank’s rate is still lower than the rate of inflation, then the money can be deposited in the form of gold. In contrast to the property, the price of gold is more affordable (since you can buy the gold at the quantity of one gram only, or even less than that), and therefore more liquid (easily sold/liquidated into cash) rather than property assets such as land, rice fields, or buildings.

Because the original function of gold is only for hedging, then gold does not offer the growth of the value of assets invested, but only the increase of price (read the details here). That's why when compared to investing in growth assets such as stocks, corporate, fields, farms to plantations, then investing in gold is less favorable because the increase in value is only able to beat the rate of inflation only.

But on the other hand, gold also has a low level of risks, because it has a definite value that is based on weight, which will never change forever. I mean, if you buy gold weighing 10 grams in 1990, then the weight will still be 10 grams today, and will be 10 grams forever. This is different from investments in properties that could suffer depreciations, or in stocks which the value (and of course the price) of the stocks could be significantly impaired if the company’s performance declines or even went bankrupt.

However, it was a story of the past. Today, the gold has many functions in addition to its original function for hedging as we have discussed above. And one of the functions is for trading. Investors, or traders to be exact, can take advantage of fluctuations in the price of gold, by way to buy it at a low price and then sell it back at a high price. In this case the ‘investment’ becomes risky, that is if the trader fails to sell the gold at a higher price. And that is why when the price of gold has recently dropped, then the gold traders suffer losses, just like the stock traders whenever the JCI was fall.

But what about the real investors that making gold as an instrument for hedging their assets? Of course, they’re keep cool. For example, I myself had bought a bracelet weighing 3 grams for my little daughter worth Rp1.6 million. If the recent declines in gold price also influenced the price of gold jewelry that is sold in stores, then the price of the bracelet may also down to about Rp1.2 million. But was that means that I suffer loss? Of course not, because from the beginning I have no intention to resell the bracelet at a higher price.

Speculate with Gold

As we've discussed many times in this blog, if you want to invest or trade (in stocks, gold, or others), then it is fine (although I myself prefer to invest). One thing you have to avoid is to speculate. In connection with trading (in stocks, gold, or whatever), speculation is a way of trade to make extraordinary profits, but at a very high risk of loss (like they always say, high risk high gain). The trick? By using the funds we don’t have, aka debt!

Unfortunately, the way to 'invest' in gold (that flourishes recently) is actually leading to that kind of speculation, even though the subjects deny that they are speculating.

One of them, ‘Kebun Emas’ (literally means as the ‘plantation of gold’). Kebun Emas is a method where you can get gold in large quantities by utilizing the facility of pawn provided by pawnshop or bank. In the conservative method of gold investment, with the money of Rp5 million you will obtain 10 grams of gold (assuming that the gold price is Rp500,000 per gram). But with the facility of pawn/mortgage, you can obtain 100 grams of gold with a capital of only Rp14 million, by pawning the same gold repeatedly.

But you have notice that the additional 90 grams of gold was a loan from the Pawnshop, so your gold is still only 10 grams.

So here’s the difference. In an 'ordinary investment', if the price of gold rose 25% from Rp500,000 to Rp625,000 per gram, for example, the you will obtain the profit Rp1.25 million (25% of Rp5 million). But if you applied the method of Kebun Emas, you will reap profit of Rp12.5 million aka tenfold, because you hold 100 grams of goold instead of 10 grams only. Of course, the profit is gross because you have to pay the costs of administrative and pawn (which is actually an interest) to the pawnshop. But assuming that these costs are lower than the gains due to rising gold price, then your net profit will still higher than the ‘ordinary method’ of gold investment.

However, the story would be totally different if the gold price was dropped, where losses will be doubled, since you can not pawn the gold forever (you have to redeem it after a certain time), or the interest will continue to increase over time until the pawnshop have to seize your gold (so your loss is 100%). And that’s what I mean high risk high gain. This kind of high risk doesn’t apply to traditional gold investors, where the declining of gold price will always be an opportunity to buy earrings, rings, and necklaces to add the collection.

Other than the method of Kebun Emas, there also different ‘investment methods’ with various modifications, but the goal remains the same: To achieve larger profits, and if possible, in a short time. At this point, the gold has lost its function as a hedging instrument, because it is used as a tool to 'achieve maximum profit in the shortest possible time'.

Speculate in Stocks

As you know, in stock you can also trade instead of investing. And beyond them, you can try to speculate as well. The trick? Well, check out your brokerage house, it must provide the facility of margin (loan to buy stocks) that you can use at any time, to achieve greater profits than usual. From the point of view of that speculation is the activity of stock trading without careful calculation/analysis, then this kind of trading (by using margin facility) is not a speculation, as you know what are you doing.

But from the definition of that speculation is the activity that expects huge profits by take greater risks, then stock trading in this way is clearly a speculation. You can make great profit when the market is bullish, but you will suffer greater losses when the market is bearish, because your brokerage company will continue to withdraw interest from the funds you borrow, until you’re forced to sell your stocks in much lower price (if the market was dropped deeply).

As an investor, I also make trades sometimes by looking at fundamental aspects, of course. But what if I use the margin? Well, just don’t! I have been hear a lot of stories of people which his portfolio, or even his life is falling apart because of this kind of greed, and to be honest, I do not want to be one of them.

Anyway, I think it all rooted from the psychological side of an investor as a human, which determines whether he will become a real investor, trader, or even an anti-investor aka speculator. I mean, if you can control your greed nature since the beginning, then your creativity will lead you to make a profit in right ways, and then your assets will grow naturally over time.

But if you’re include those people who like to make 'high gain in the short time', then well, your creativity will lead you to an edge of the roof of a high building, and you’ll jump down. And believe me, it really happened to certain people.

Original article was written at April 18, 2013