The 'secret' gold market that could enhance your profits

If you've been following me in recent weeks, you'll know that I'm in the mood to buy gold. You'll probably be aware that prices are moving steadily upwards, and I reckon they're going to stay on that trajectory for a while.

There's a hidden 'quirk' in the gold market that could put you ahead of most private investors. Let me explain.

There are two markets for gold

Here's the angle that most people don't or can't grasp. There's a big difference between 'paper gold' and real gold. The market is now showing signs of a split between physical, like coins from its paper derivatives (that is anything other than physical possession). This is an important development.

Start your trial of MoneyWeek today

Get unparalleled financial insight, analysis and expert opinion you can profit from.

Start your trial

Sign up for MoneyWeek’s free twice-daily newsletter.

Join more than 165,000 subscribers and keep yourself informed with latest financial news, insights and expert analysis to help you understand what really matters when it comes to your finances.

Join more than 165,000 subscribers and keep yourself informed with latest financial news, insights and expert analysis to help you understand what really matters when it comes to your finances.

Sign up

To show you what I mean, and how we can profit from this quirk, let's take a quick look in the history books.

The lesson from the original gold traders

Gold has always been recognised as a store of value. Every civilisation has used it to save and flaunt wealth. Now, before the banks invented safety deposit boxes, people would deposit gold with the goldsmith. He was trusted within the community and had a secure vault.

Of course, if you deposited your gold with the goldsmith, you'd want a receipt. And that's exactly what you got a certificate. Now this certificate had a value: the amount of gold that it backed at the goldsmith's vault. Pretty soon, people were exchanging these certificates (or paper gold) as if they were the real thing, which led to a new form of trading in the gold business.

Bankers invented paper gold to maximise their profits

The goldsmiths soon realised that hardly anyone ever came to claim their gold anymore. Everyone traded the certificates as if they were gold. Nobody had a clue what was in the vault. And this gave the goldsmith an opportunity.

Why not print a few more certificates? And that's exactly what he did. He lent out gold certificates and charged interest on the back of them.

Sound familiar? Of course: in effect, the goldsmith had become a modern-day banker.

• Discover how to profit from oil without ever owning a single barrel
• Why NOW is the best time to put a few carefully selected oil investments into your portfolio

Taking deposits and lending out many times their value is the crux of modern day investment banking. But there's a problem with this. If the banks/goldsmiths go too far and create too many certificates, people smell a rat. And that's when they get fearful of paper gold. It can even come to a point when the paper stuff just isn't recognised anymore.

Physical gold can way outperform the paper market

Paper gold has never been, and never will be the same as gold. It's exactly the same today as it was in ancient times. Nobody knows for sure if what's on the certificate is really backed up by anything.

Paper gold is only worth as much as the faith in the institution that prints it. By paper gold I'm talking about futures and options, exchange traded funds, unallocated gold accounts, gold certificates, digital gold.

And when people become sceptical about the financial system, sceptical about the banks, that's when they go for physical gold. After all, do you want to hold paper backed by banks that are going out of business?

That's why the physical gold price is moving up. Even the media is talking about gold coins costing up to 40% more than the price of spot gold in Greece.

In Germany and Austria too, physical gold is getting tough to get hold of, and if you want it now, you have to pay a significant premium. Even here in the UK, the bullion traders are telling clients they'll need to wait up to six months for delivery.

This has all happened before. Only gold is gold. I've been reading un-substantiated (and possibly in the realms of conspiracy) reports about the amount of gold that's actually physically available to back up all the paper gold.

Get this: they tell us that there's 100 times more paper gold floating around the financial ether than there is gold to back them up. Now, bearing in mind that physical gold (in the form of, say, Krugerrands) costs only about 5% more to buy than paper gold (for the moment), then why take the risk of holding paper?

And anyway, if the market continues to split, your physical gold will perform better than paper anyway.

By all means place your bets on paper gold that's a trade, but make sure you get a slice of the physical market too. That's your insurance.

This article was first published in the free investment email The Right Side on 16 June 2010.

The FSA does not regulate certain activities. This includes the buying and selling of commodities such as gold. Your capital is at risk when you invest in shares - you can lose some or all of your money, so never risk more than you can afford to lose. Always seek personal advice if you are unsure about the suitability of any investment. Past performance and forecasts are not reliable indicators of future results. Commissions, fees and other charges can reduce returns from investments. Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Please note that there will be no follow up to recommendations in The Right Side.

Managing Editor: Theo Casey. The Right Side is issued by MoneyWeek Ltd. MoneyWeek Ltd is authorised and regulated by the Financial Services Authority. FSA No 509798. https://www.fsa.gov.uk/register/home.do