When investing in gold mining stocks, reduce your risk by buying into stable companies at sustainable prices.

Is investing in gold mining stocks on your mind? We don’t see gold as an essential part of a sound portfolio, and, in fact, gold investing is a poor choice for most investors. For one thing, it involves considerably more guesswork than other aspects of investing.

The markets for widely traded goods like gold (as well as oil, foreign exchange, U.S. government bonds and so on) are inherently unpredictable. These markets are so big that there is no practical limit to how much you can trade in them. It follows that if you could predict them, you could wind up acquiring a measurable proportion of all the money in the world. Nobody ever does that.

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Investing in gold mining stocks: Stop trying to predict future performance, and you’ll win more.

We think it’s a mistake to build your portfolio in such a way that you have to do the impossible such as predict the future direction of gold or any commodity. You’re better off focusing on investments that can generate current income plus long-term capital gains.

Three key choices for that kind of investing are stocks, bonds and real estate.

Stocks are the best choice for most of us right now. They are far more liquid than real estate, and are less vulnerable to a rise in interest rates. (A rise in interest rates would push up mortgage borrowing costs, which could cut into demand for real estate.) Stocks also provide much higher income than you get in bonds with current low interest rates. They are also less sensitive than bonds are to a rise in interest rates.

One special risk to gold investing is that some investors take it to extremes. They invest too much capital, and some use options, futures or margin loans to gain leverage. This magnifies their losses when they are wrong on gold-price trends.

If you want to invest in gold, the best way to do so is to include some gold stocks in your stock portfolio. But don’t go overboard. Limit your gold exposure to a portion of the exposure you would otherwise devote to the resources sector of the economy.

Furthermore, avoid buying gold mining stocks that trade at unsustainably high prices. This is usually due to broker hype or investor mania about the underlying commodity such as gold. Instead, we focus on reasonably priced mining stocks with favourable geology.

Use these three tips to decrease risk when you invest in mining stocks

1. We generally stay away from mining stocks that operate in insecure and politically unstable regions.
2. High-quality mining stocks should have strong balance sheets with low debt. Junior explorers and developers should have a major partner who can finance a mine to production.
3. We always look at the market cap of mining stocks against the estimated value of the mineral resource they have in the ground. We like a mining stock’s market cap to be no more than half the value of the company’s mineral reserves. We assume that the company will be able to expand its ore reserves after the mine opens, but if the mineral reserves are double the mining stock’s market cap, it provides a margin of safety.

Investing in gold mining stocks: Focus on major companies with mines already in production for a safer investment

Strong investor interest in gold investing increases the prices of many gold stocks, including a number of junior exploration firms that have yet to establish a history of production or cash flow. This also pushes up interest in even the most-speculative juniors. Promoters then step up to exploit this interest.

In fact, when interest in gold stocks is high, some heavily promoted juniors change their focus to gold exploration simply to take advantage of investor interest in any stock that has the word gold in its press releases.

When you think about gold investing in relation to a junior firm with nothing but promise, it pays to remember that it’s far easier to create an intriguing investment opportunity than a successful exploration program.

Mind you, both tasks take some ingenuity. Both call for an injection of capital and various professional services. However, all businesses start out as investment opportunities. But few investments, particularly junior mines, turn into profitable businesses.

Follow our three-part Successful Investor strategy while investing in gold mining stocks 

1. Invest mainly in well-established companies;
2. Spread your money out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; the Consumer sector; Finance; Utilities);
3. Downplay or avoid stocks in the broker/media limelight.

Some investors consider gold to be a crisis investment, because it has traditionally been viewed as a “place of safe harbour” for investors. What appeal, if any, has gold had for you?