Deviant Investor about Gold, Counterparty Risk & Investing In Paper Assets
OCTOBER 17, 2012
The author of this article explores maybe the single most important risk of the current and past decade: counterparty risk. In fact, as an investor you MUST take that risk into account. Gone are the days where investing in paper assets would yield high percentages and worst case lose a couple of them. In today’s reality, losing everything while being in the right asset class, is the “new normal”. Indeed, investing in gold via MF Global would have returned zero, while gold and silver were the best performing and safest asset classes of the past decades.
The reality is that the financial paper cycle is over and that the commodities cycle is the one that is creating true value (wealth). The more our governments try to stop that trend, the harder the consequences … for the ones who didn’t see it coming AND for the average hard working citizen who is not aware that his/her savings are melting down.
Gold has been wealth and money, a store of value, and a means of exchange for more than 3,000 years. Only recently has debt been widely considered wealth. A US government T-Bond is considered “wealth” because the government promises to repay the loan with interest. Similarly, a corporate note is “wealth” because the corporation has promised to repay the note with dollars, and those dollars are still considered valuable. (Dollars are accepted because dollars are accepted.)
Counterparty (the other party in the transaction) risk to your net worth and purchasing power is now more important than ever before! The counterparty to your investment could be the US government, the corporation that issued a bond, the Federal Reserve, a bank, a broker, a clearing house, or other financial business.
What happens if the government refuses to honor the T-Bond debt? What happens if the corporation becomes insolvent and can’t pay its debts? What happens if MF Global takes “segregated” customer funds and pledges them to a bank? MF Global may owe its customers money. However, if MF Global can’t or won’t pay, then the customer has experienced an unfortunate counterparty risk that was previously unknown or misunderstood. Counterparty risk can destroy your wealth and net worth.
Paper assets, such as stocks, bonds, derivatives, brokerage accounts, certificates, $100 bills, and other promises to pay, can become worthless. The government can devalue the currency and diminish the purchasing power of those paper assets to a tiny fraction of their previous value. The government could also collapse, and all previous government debts could be repudiated by the new government. These things have happened in other countries.
Many countries have replaced severely inflated currencies with “new” currencies worth 1,000 of the previous currency. Knocking off zeros from a national currency is common. The United States has not experienced severe inflation in over 100 years, so we forget that it is actually not unusual. But, severe inflation and/or hyperinflation in the United States are becoming more likely since all such inflations start with excessive government spending and “money printing” (Quantitative Easing – injecting liquidity into the financial system) and accelerate toward lost confidence in the currency. Your purchasing power and your real net worth in an inflating currency can diminish rapidly.
We can also lose net worth the old-fashioned way – our assets become less valuable. When the NASDAQ crashed in early 2000 from about 5,000 to about 1,000, many people lost a substantial portion of their paper assets. When gasoline subsequently increased in price from about $1 to $4, our paper assets lost much of their purchasing power for most other commodities. During such inflation, the purchasing power of our net worth will severely decline.
What if we measured our wealth, our purchasing power, or our net worth in ounces of gold, not dollars? This is an ancient idea based on the concept that gold has universal value while paper assets come and go and eventually decline in value to zero.
In this example, our net worth in dollars increased. However, when measured in ounces of gold, it decreased.
So what is your net worth when measured in gold? Is it increasing or decreasing? Are you confident that your paper assets are safe from both inflation and counterparty risk? Could those paper assets or the currency they are denominated in (dollars, euros, etc.) collapse in value? Would you feel safer if more of your net worth was invested in gold, which has NO counterparty risk?
Central Banks around the world and especially in the United States and Europe are creating a huge number of new dollars and euros in their efforts to reflate the banking systems and “paper-over” the insolvency of sovereign nations. Those newly created dollars and euros reduce the value of all previously existing dollars and euros, so we can be confident our dollars and euros will purchase less in the future. Similarly, we can be confident that more dollars and euros will be required to purchase an ounce of gold in the future.
What is your net worth when measured in ounces of gold? What is your golden worth?
Get Weekly Expert Analysisand the special report:
6 Gold & Silver Scams to Avoid
The information, opinions, and financial data presented are for educational purposes only and are not intended as investment advice. No guarantees are made as to the accuracy of the information provided herein. Situations can change from day to day. Every investor should do their own due-diligence to determine which investments are best for them.
You must assume the responsibility and liability for all decisions that you make on the basis of the information herein contained. GoldSilver.com, makes no warranties, expressed or implied, as to the fitness and accuracy of the information provided or for the results obtained by using the information. Those making investment decisions based on any of the information presented should do so in the knowledge that they could experience significant losses. In no event shall GoldSilver.com be liable for direct, indirect, or incidental damages resulting from the use of the information.