Buying Gold

Buying Gold: The Best Way to Use This Precious Metal

by Keith Fitz-Gerald
Investment Director, Money Morning
Thursday, July 10, 2008: Issue # 818

A lot of people are buying gold for the wrong reasons right now. Yesterday, our colleagues published a must-read explanation… including the right way to own this precious metal. Below, please find the full article from Money Morning Investment Director Keith Fitz-Gerald.

One of the things people don’t understand about buying gold for diversification is that it doesn’t work all the time.

It works over time.

That means that you can’t simply switch from one asset class to another when the going gets tough and expect miracles. Nor can you expect higher returns.

And that’s the really cruel part.

Many so-called alternative investments, gold being the most notable, are being sold right now on the basis of recent high returns to salivating investors desperate to stop the bleeding in their portfolios.

Buying Gold Offers Portfolio Diversification

No question, buying gold offers portfolio diversification; but near all-time highs, its “protection” is debatable at best, when viewed against the harsh light of historical data.

Which is why, at the risk of receiving some very testy email, we have to point out that:

If you bought gold the last time it was this high, you’d probably regret it now.
If you had invested $10,000 in gold in January 1980, the current value of your investment would be $10,600.
Now, compare that to the $279,000 you would have if you had invested that same $10,000 in the S&P 500 Index in January 1980 and you’ll see what I mean.

Does this mean that investing in gold stocks is worthless when it comes to riding out tough markets?

No. Not for a New York minute…

A Powerful Investing Hedge - Buying Gold

Gold remains a powerful hedge and one that every investor should think about… but for reasons that are not commonly understood.

You see, while gold has never been proven to be a statistically viable inflation protector, it has a significantly correlated 10-to-1 relationship with interest rates and bond prices, which react to inflation. Therefore, if interest rates rise by 1%, the face value of bonds should fall 10%, but gold should rise by 100%.

Which suggests that 10% of the value of bonds ought to be put in gold… as a hedge.

Here’s how such an example would work:

If we allocate $10,000 to this strategy, $9,000 would go into bonds and $1,000 into gold.
If rates rise by 1% (as they’re likely to do and then some), the bonds should fall 10% to $8,100 and the gold should rise by approximately 100% to $2,000.
Overall, our portfolio would be worth $10,100 (give or take), which is right about where we started.

That suggests a portfolio of bonds and gold is safer than either bonds or gold in isolation. [See our report on How to Build Wealth for information on proper asset allocation.]

Obviously, gold has been bid up substantially in recent months. So the 100% rise we expect based on historical patterns may not be as extreme, nor may it rise another 100% from current levels, but the point remains valid - we don’t buy gold because it hedges bad times.

Buying Gold Protects Your Bond Income Stream

We buy gold because it protects the income stream we get from our bonds… particularly when the economy is facing severe inflationary pressures like it is now. So how do we make our move and when?

Everybody has their own preferences for buying gold investments, including us. There are mining companies, bullion, gold coins and even jewelry. We prefer the SPDR Gold Trust ETF (GLD). There’s no delivery risk, it’s liquid, and you can buy and sell easily through any online brokerage. Plus, as so many residents who lived through Hurricane Katrina found out, you don’t have to worry about Mother Nature or hooligans stealing it either.

As for when to buy gold, now is probably a pretty good time. The U.S. Federal Reserve has only just begun to acknowledge the inflationary embers it’s been fanning for a long time. And, as usual, they’re dramatically underestimating the 9% to 10% we’re feeling in our pockets. So, even if they don’t officially raise rates, odds are that the markets will anyway, as traders cope with rising costs on their own.

Though, as you might suspect, there is a downside. By taking part of the portfolio that would otherwise be placed in bonds and presumably generating income, this strategy dampens the returns we could potentially achieve with bonds.

But given gold’s protective qualities over time, we think that’s a good bet.

Good investing,

Keith

Keith Fitz-Gerald is a former professional trader and licensed CTA, advising institutions and qualified individuals. He regularly contributes to MoneyMorning - a free service that helps investors profit from the “seismic shift” in the global economy. Follow the link to get Money Morning before the market opens each day. They’ll immediately send you their free report, Two Stocks Ready to Rocket With Oil Prices.

Today’s Investment U Crib Sheet

While gold has been in a major uptrend over the past few years - hitting an all-time high of $1,030.80 on March 17, 2008 - shares of the natural resource companies that bring the gold to market have performed considerably better. That isn’t likely to change.
Over the past 50 years, major gold mining companies have risen at an annual rate of approximately 12%. That’s better than the return of the S&P 500, although the trade-off has been head-snapping volatility along the way.
The most best way to buy conservative blue chip gold mining stocks is to read Investment U Issue #814, Market Vectors Gold Miners… A Conservative Blue Chip Stock.