Ray Dalio Reveals the Great Trap of Holding Paper Gold Over Real Metal

Bridgewater founder Ray Dalio, in a recent interview with Zerodha's Nikhil Kamath, warned investors against choosing paper promises of gold over the physical metal in pursuit of yield.

Dalio said this choice is 'the trap' that has ensnared investors for a long time. During the discussion, which came amid gold's record rally, Dalio said that investors should understand the distinction between physical gold and gold-backed financial vehicles.

Physical gold is 'the only money that you can have. Nobody has to give you anything to have it, but all other money is dependent on somebody giving you something.' Dalio explained that sovereign gold bonds and gold certificates introduce credit risk. 'You're still dealing with credit risk,' he said about gold lending schemes. 'What you're getting paid for is credit risk. So, it's not gold. It's a promise to get your gold back.'

The Great Trick of History

Dalio said the problem of gold promises and credit risk dates back centuries. 'The great trick of history, and everybody believed it back then for a long time, is that if I hold the promise to get the gold, then I will get an interest rate. And I could always turn my money in for gold,' he explained. The logic is, why hold physical gold that generates no income when you can have a paper claim on gold that pays interest?

'And that was the trap,' Dalio remarked. When Kamath said that investors can monetise physical gold by lending it out for returns, Dalio said: 'That ain't gold.' These instruments represent promises rather than ownership. At the same time, investors face the risk that the promise won't be kept, especially during financial downturns.

The Risk of Interest Rates

Physical gold does not yield regular income, but Dalio said it is a feature of the precious metal, and is not a bug. 'Gold doesn't have an interest rate' because it's not someone else's liability, the billionaire investor said. 'You have an interest rate... on the promise to get your gold back. That's what everybody believed, and that's the great trick of history,' Dalio added. Interest rates existed to compensate for the risk of not getting back the gold.

Physical gold's 'confiscation risk is less' as it does not rely on a company's solvency or willingness to honour its obligations. Additionally, 'you can't deflate its value,' Dalio said.

With US bonds yielding about 4%, investors must ask themselves, "if gold goes up by more than 4%, then I'm better holding gold, and if it goes up by less than 4%, then I'm better holding the bond,' Dalio added. However, this approach applies when comparing assets of similar risk. Note that paper gold instruments carry credit risk that physical gold does not.

Confidence Shift and the Value of Gold

'Gold fell out of fashion as a money, and bonds fell into passion,' Dalio said, describing how confidence in paper claims has waned. However, when confidence falters, the distinction between physical metal and paper gold becomes very clear.

In all, Dalio believes the extra yield offered by gold-backed instruments comes with considerable credit risk that physical gold is meant to avoid.

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