A little goes a long way in your portfolio

Are you ever tempted to invest in gold but frightened by its sharp ups and downs? Some gold investing gurus will tell you that gold is the one safe place left to invest your money… and that it will hit $5,000 an ounce within a few years. Skeptics say that gold is much too volatile. For instance, it soared by nearly 50% to $1,000 an ounce between October 2008 and February 2009 and then pulled back 10% to $900 by March.

There are good reasons to put a portion of your assets in gold — if you do it the right way. Here’s why and how…

GOLD PROVIDES DIVERSIFICATION

Stocks, bonds and real estate are all very dangerous for investors now. Historically, gold has done well when the economy is shaky… investors panic… and stocks and bonds seem too risky.

Example: In the economically troubled seven-year period from 1973 to 1980, the price of gold rose by 2,300%, from $35 to $850 per ounce.

Right now, the federal government is making unprecedented moves to shore up the economy and ward off deflation by lowering interest rates to nearly zero and pumping trillions of dollars into bailouts and stimulus plans. This raises the real possibility of soaring inflation in the coming years. Inflation typically leads to higher gold prices because investors realize that their paper money is losing value.

That doesn’t mean you should buy gold because you think you can make a killing. Gold prices are notoriously hard to predict. Investors can’t analyze gold like they can a company, which has quarterly earnings and may pay a dividend.

The truth is that, as an investment, gold’s average annualized returns have only barely kept up with inflation. For example, back in 1979, I used my college graduation money to invest in 10 ounces of gold coins at $664 per ounce. I was sure that prices would quickly soar to $2,000 per ounce because of high inflation. But after three decades, the value of my gold coins has risen to less than half that, a gain of less than 50%.

Where gold does shine, however, is as a terrific way to diversify your portfolio. Its price has so little correlation with stock and bond returns that adding just a little gold can lower your overall volatility and protect you in bad times. Gold held its value in the credit crisis of 2008, rising 4% when almost every other major asset class plunged in value. In the past decade, gold has increased by about 13% annually, on average, compared with a 3% annualized drop for the Standard & Poor’s 500 stock index.

INVEST FOR THE LONG-TERM

I recommend gold only for clients who can stay invested for 10 years or more and are willing to accept wild, short-term swings in gold prices. Consider the following guidelines…

  • Devote a maximum of 3% of your overall portfolio to gold.
  • Invest fixed amounts at regular intervals, say once a month over the next year, because gold prices bounce around. That way you are likely to buy during periods when gold pulls back, which happens often.
  • Rebalance gold holdings at least once a year. If gold rises in 2009, you will want to take some profits at the end of the year and trim back to your original 3% target.
  • HOW TO INVEST IN GOLD

  • For conservative investors: Avoid buying into gold mines or gold futures contracts. Just invest directly in the mineral. That gives you the most control over your investment. Best ways to invest directly…
  • Gold bullion coins. This is pure gold metal cast as coins. Buy only from a dealer found through the Professional Coin Grading Service (800-447-8848, www.pcgs.com) or the Numismatic Guaranty Corporation (800-642-2646, www.ngccoin.com), whose members have to abide by strict standards and procedures. Both organizations offer a money-back guarantee for grading accuracy and authenticity.

    Ask for one-ounce coins, either South African Krugerrands, Canadian Maple Leafs or American Eagles. These are the most widely traded coins and the easiest to sell if you want or need to. Prices are based on the market price of gold (which you can find at www.kitco.com) plus a 3%-to-5% premium charged by dealers.

    Drawbacks: The IRS classifies gold coins as a “collectible,” which means that capital gains on the sale of this type of gold are taxed at a flat 28% rate — not at the usual 15% rate for most other capital gains. Also, you may have to pay to store your coins in a bank safe-deposit box. Another option is to keep your coins in a home safe. Check to see what your homeowner’s insurance policy will cover, or consider becoming a member of the American Numismatic Association (800-367-9723, www.money.org) and getting coverage from its insurance plan.

    SPDR Gold Shares (GLD), a gold exchange-traded fund (ETF), may be a better option if you don’t want the drawbacks of actual physical possession of your gold. Each share represents one-tenth of one ounce of actual gold. With a total market value of more than $31 billion, the fund now is the second-largest ETF on the market. The gold backing the shares is kept in vaults in Europe and audited regularly. Keep in mind that the 0.4% annual expense ratio will take a bite out of your account every year.

    Recent share price: $91.30.

  • For more aggressive investors: If you are willing to take more risk, consider investing in stocks of precious-metal firms and gold-mining companies. When the price of gold rises, these stocks tend to gain even more because the cost of producing gold doesn’t necessarily increase, which means much higher profits for the company. This is especially true if a company finds new reserves or develops more cost-effective mining technology. Best ways to invest…
  • To mute volatility, use a mutual fund focused largely on gold. Gold-related stocks can plunge a lot faster than gold itself because a company’s profitability can disappear quickly — and the stocks carry the additional risks that come with an investment in any company, including the danger that management will make bad decisions.

    I like Vanguard Precious Metals and Mining Fund (VGPMX) because of its low volatility and low fees. The fund invests in stocks of companies that mine for gold and other precious metals.

    10-year annualized performance: 13% as of February 28, 2009. 800-523-7731, www.vanguard.com.

    If you prefer a passively managed fund that tracks an index and whose expenses likely are lower than a fund whose managers choose the investments, consider Market Vectors Gold Miners (GDX), an ETF that owns shares in the world’s leading gold-mining companies.

    Recent share price: $33.08.