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Buying Gold: Avoid These Three Mistakes

Before buying gold, avoid these three common mistakes and stay focused to make money.
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Editor's note: As part of our partnership with PBS's Nightly Business Report, TheStreet's Alix Steel appeared on NBR to discuss common mistakes gold investors make. (Watch video)

NEW YORK (TheStreet) -- Wild price swings in gold can cause investors to lose focus and lose money.

Over the past 10 years

gold prices

have surged from $282 to a record intraday high of $1,264 an ounce, but daily volatility can lead to big trading mistakes.

The gold market is ripe with peer-pressure buying. When gold makes a big double-digit move up or down, panicked retail investors can be tempted to either jump into the market for fear of missing the rally or to sell their positions because they don't want to be stuck owning "cheap" gold.

"Most individual investors lose in the gold market because they love

the chase/buy excitement," says Scott Redler, chief strategic officer at


The first trick to avoid the trading frenzy is to identify your time frame and your reasons for owning gold. An investor buying gold coins as a 30-year investment will have to ignore day-to-day volatility, compared to traders who will try to capitalize on these price fluctuations.

The three most popular ways to buy gold are gold coins and bullion, gold stocks and gold exchange-traded funds.

The three money-losing mistakes many investors make are overpaying for bullion, picking bad stocks, and buying ETFs for the wrong reasons. Before you pull the trigger, find out how to avoid these common blunders.

Gold Coins and Bullion

Number one rule: Don't get ripped off.

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The conventional premium on a one-ounce bullion coin is 5% to 10%. Coins typically come out of the National Mint, where they are made at a 4% mark-up; the retailer's margin is 1% to 3%.

To calculate the premium subtract the spot price of gold from the price you are being quoted, divide that number by the spot price and multiply by 100.

Like the chart shows, as of Aug. 11, 2010, a one-ounce gold bar at

sold for $1,225.90. Using the spot price of $1,200, the bar has a 2.1% mark-up, which means that the gold price only has to rise 2.1% from current levels for you to break even on your investment.

Premiums though can reach as high as 75% or more based on the gold item. Kitco is also selling a one-tenth of an ounce gold eagle coin for $162.12, which is a 35% mark-up.

To avoid getting ripped off, first establish why you want to buy gold bullion. If you just want to own gold as a long-term investment then buy gold as close to the spot price as possible. If you want to own gold to use as money -- if you are a "survivalist" as Jon Nadler, senior analyst at

, says -- then you need smaller gold coins, like one-tenth of an ounce, and will have to pay the premium.

Nadler's take is that an individual investor shouldn't spend more than a 10% mark-up when buying gold, but acknowledges that "everyone has their own threshold."

Where investors also tend to go astray is by buying semi-numismatic or numismatic coins, otherwise known as rare coins, which come with huge premiums that seldom recoup their value.

A good rule of thumb is to leave rare coin buying to rare coin dealers. Nadler advises that consumers interested in rare coins go to professional auctioneers like Bowers & Merena or Christie's who have experts on staff and can objectively grade the coins the same way an antique dealer would appraise goods.

If a broker tries to sell you a story with the coin like it's from the "old world and there are only a few thousand in existence," experts advise to go elsewhere.

"Don't confuse investing in gold with the things being sold as gold investments," cautions Nadler. "You want something that tracks the price of gold as close to dollar to dollar as possible."

Gold Stocks

Gold stocks are a tempting way to buy gold because many analysts think they offer as much as 3:1 leverage to gold's spot price.

But the correlation isn't an exact science and you still have to pick the right stocks, which is a risky business.

Gold is up 9.5% year to date while the world's largest gold miner,

Barrick Gold


, is up only 10.79%. Other stocks are mixed.

Newmont Mining

(NEM) - Get Newmont Corporation Report

has rallied 22% and

Kinross Gold

(KGC) - Get Kinross Gold Corporation Report

has fallen more than 17%.

Many investors make the mistake of buying small gold miners that are in the exploration phase with no cash flow. Picking among these stocks is like buying a lottery ticket -- very few companies actually strike gold and become profitable.

A safer way is to pick gold producers with good management, and companies that mine in geopolitically safe areas, produce an ounce of gold cheaply (i.e. low cash costs), have a near perfect correlation to the gold price with long-term inventory, and strong reserve growth.

Then you need to narrow down that list to find the companies that will give you the most leverage to the gold price.

Adam Graf, director of emerging miners for

Dahlman Rose

, models 50 companies on a forward basis using forward curves. "On a theoretical basis, if gold moved up $100 an ounce, what does the change in the current value do based on what the forward looking cash flow should do?"

Pure gold companies are more likely to have a direct correlation to the gold price than a diversified miner.

Randgold Resources

(GOLD) - Get Barrick Gold Corporation (BC) Report

, up 10% this year, sees higher gold prices trickle down to its profits within a few days. "We ship

gold twice a week and we set the price on the day after we ship," says CEO Mark Bristow. Bristow attributes his company's success to the fact that it focuses solely on gold and isn't diluted by exposure to silver and copper prices.

Another mistake investors make is buying the wrong amount of stocks.

J.C. Doody, editor of

, bets on 10 gold stocks and his list is up 735% since April 2001, while gold prices are up 368%.

"The beauty about being an individual investor is you can outperform all the gold funds and the gold ETFs by picking good stocks and having the right number of good stocks."

Doody likes 10 because it allows him to take some risk with explorers or junior miners as well as getting the safety from a major.

"Frankly, there aren't 30-40 stocks in the gold space worth buying," says Doody. "If you've got too many the best you're going to be is a mediocre mutual fund and if you have too few you're just taking on too

much risk."

Finally, some investors get too spooked too fast and wind up selling out of gold stocks at the wrong time.

Leverage swings both ways, so if the gold price drops 10%, gold stocks can plummet 20% to 30%. Gold stocks move with the broader equity market and are one of the first sectors to suffer from bad headlines, panic and risk aversion.

"It inhales and exhales 20-30% at least once or twice a year," says Pratik Sharma, managing director at Atyant Capital, who urges investors to stay calm. "Ultimately what you have to realize 5-6-7%

price swings ... these things are meaningless when you have a sector that moves 20-30% several times a year on the downside."

Gold ETFs

There are three physically backed gold ETFs traded in the U.S.:

SPDR Gold Shares

(GLD) - Get SPDR Gold Shares ETF Report

iShares Comex Gold Trust

(IAU) - Get iShares Gold Trust Report

ETFS Physical Gold Shares

(SGOL) - Get abrdn Physical Gold Shares ETF Report


The ETFs track the spot price, provide no leverage and are easily tradable. For each share of these ETFs you buy, you generally own the equivalent of one-tenth of an ounce of gold which is stored by a custodian --






, respectively.

A mistake investors make with the gold ETFs is thinking that they actually own physical gold.

Wrong. The funds hold gold and issue shares, but you own a paper representation of gold.

Also, if a fund needs more gold to meet investor demand, it will often buy gold contracts from the Comex instead of the bullion. Historically, when you let your gold contract expire you received physical delivery of the commodity; now you just get a certificate. So your shares of the ETF might actually be a mixture of bullion and futures contracts.

It's also hard to determine if the gold in the ETFs really exists.

Will Rhind, head of U.S. operations for ETF Securities, says the custodians for SGOL like




provide a bar list of all the individual allocated bars daily. Twice a year there is a third-party audit by Inspector International.

James Turk, founder of

, warns that even if the gold is really there, the fund's shares can be sold short so two people can own the same ounce of gold -- the owner of the original shares and the investor who is borrowing the gold.

Gold ETFs are also more expensive, with fees ranging between 0.25%-0.40%; storing physical gold can cost 0.15%-0.18%.

Another mistake investors make is thinking they can redeem their shares for the physical metal. In terms of SGOL, an investor would have to redeem in whole lots of 50,000 shares (5,000 ounces or $6 million), but only through an authorized participant, which is not readily available for retail investors.

Dave Fry, founder and publisher of ETF Digest, says if you want to buy a redeemable option, closed-end fund,

Sprott Physical Gold Trust

(PHYS) - Get Sprott Physical Gold Trust Unit Report

is attractive.

An investor is allowed to redeem a minimum of 2,500 shares on the 15th of every month, but you still have to arrange for pick-up and storage. The fund currently has 582,417 ounces of gold and trades at a 9.3% premium to the net asset value. Sprott Asset Management is in the works to launch a redeemable silver fund as well.

Fry says gold ETFs are good investment tools, but "if you're buying gold, get gold."

No matter which way you decide to buy gold, the metal should be part of your portfolio. But it's important to sidestep these common mistakes to get the most gold for your buck.


Written by Alix Steel in New York.

Disclosure: TheStreet's editorial policy prohibits staff editors and reporters from holding positions in any individual stocks.