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Want to Add Some Glitter to Your Portfolio?

Reasons why you should--and shouldn't--invest in gold.

Katherine Yang, 03/11/2008

Headlines about the price of gold hitting record highs have been ubiquitous. As of March 3, 2008, the price had climbed to $992 per ounce. That's more than $100 per ounce higher than its previous Jan. 21, 1980, nominal peak of $870. Higher demand for the metal has been the primary driver here, mainly from concerns about the weakening dollar. When people think that paper currencies will be worth less in the future, they have historically looked to place their net worth into a more stable vehicle. And gold is typically viewed as a "safe" form of currency, as its value isn't as affected by inflation. Worries about the supply of gold have also pushed the price higher (economically, a decreased supply of a good increases its price)--for example, the recent electricity shortage in South Africa has caused some unease about mine production.

So, should investors try to get a piece of this rally? The contrarian in us says no--the best time to enter this market is when gold is trading at historical lows, not highs. We discourage investors from performance chasing, which appears to be happening here: More than $600 million flowed into precious metals funds over the past 12 months (ending January 2008). And because the gold price is hitting peak levels, it will have to drastically increase from here to deliver comparable returns. Another reason to not invest in gold at this time is that doing so implies you're making a bet on the continued weakness of the dollar--something that you can indirectly do by owning a foreign investment.

However, we don't have a crystal ball to accurately predict which direction gold will go next, and gold prices are notoriously volatile. For instance, after setting records in January 1980, the price of gold plummeted by almost 50% to about $480 per ounce by April 1980. On the other hand, gold prices have been steadily rising since last fall. And there's a case to be made for investing in gold. First of all, it can--though not perfectly--serve as an inflation and currency hedge, due to its inverse relationship with the dollar. (As the dollar's value falls, investors search for more stable forms of net worth, such as gold.) Next, it is an arguably more steady form of currency, because it isn't at the mercy of government policy--it can't be easily issued, given its limited supply. Finally, it can diversify a portfolio.

Mutual funds and exchange-traded funds are two avenues for investors who want concentrated gold exposure. Which method is right for you is dependent upon your individual investing needs and comfort levels. Each option has its merits and disadvantages, which we outline in the following paragraphs.

Mutual Funds
Precious-metals funds invest in mining stocks, such as Yamana Gold AUY. They vary quite a bit in composition. While some, such as Fidelity Select Gold FSAGX carry most of their assets in gold stocks, many, such as USAA Precious Metals and Minerals USAGX, are diversified and invest in a variety of metal miners like platinum mining stocks.

There are a couple of reasons to favor mutual funds. The movements in mining stocks are dependent upon the price of the metal as well as company-specific factors, so news unrelated to the gold price, such as changes in the management structure and cost cuts, can boost the stock price independently of the gold price. There's also some leverage, which lets you gain more from an upswing in gold. For example, say you own a share of a gold stock when gold costs $500 and the firm's costs are $100, resulting in a difference of $400. If the gold price increases by 20% to $600, this margin expands to $500, which is a 25% increase in profits (that will theoretically be reflected in the stock price).

But many of these benefits are double-edged swords. The presence of firm-related factors means that you don't get a pure play on gold, consequently reducing its role as a diversifier. The leverage magnifies losses as well. On top of that, there's currency exchange risk, as many of these firms are domiciled outside of the United States. This combination of factors has made the typical precious-metals fund notoriously volatile. That said, we point investors who are able to stomach these performance swings toward two funds in particular because of their proven management and sensible approaches: American Century Global Gold BGEIX, which invests only in gold stocks, and Oppenheimer Gold & Special Minerals OPGSX, which offers exposure to more metals. We also think Vanguard Precious Metals and Mining VGPMX and USAA Precious Metals and Minerals are category standouts, but they aren't currently available to most investors. (The former is closed, and the latter is restricted to USAA members.)

Compared with a mutual fund, ETFs can be cheaper and more tax-efficient (because they don't have to sell positions and incur capital gains in order to meet investor redemptions). ETFs can also be used to make short- and intermediate-term calls on the price of gold, because it's easy to buy and sell these shares. The danger with doing so is that it's quite difficult to make these predictions.

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