Investing in gold isn't a priority for everyone, but it has some valuable uses. For one, commodities like gold offer diversification benefit from other asset classes. Unlike equities or bonds, commodities are non-earning assets that are worth only what another party is willing to pay. However, commodities in general offer an uncorrelated benefit that can traditionally be reaped when other securities markets are performing poorly.
Gold is also a good hedge against inflation and the dollar, as the two tend to have an inverse relationship. That is, when the dollar gets weaker, gold is generally going up, because it's a limited commodity that retains purchasing power even when price inflation ratchets up.
Conversely, when the dollar is strong, gold's value decreases because you may be able to get more bang out of the greenback than from the precious metal. And, because gold is generally uncorrelated to how stocks and bonds move, it can serve as a good diversification tool in your portfolio.
Finally, unlike paper currencies, gold isn't at the mercy of government policy. Governments have historically been lousy stewards of the value of their currencies, and a gold position can help hedge a portfolio against such losses because it's not something that can be easily issued or mined. Thus, you won't see its value decrease overnight as you may if the government suddenly decides to pump up the circulation of currency in the market.
Of course, investors may also wish to directly speculate on gold prices, but as a word of caution, many investors are horrible at deciding when to invest in gold. When bullion prices are soaring, it's all too easy to jump on the gilded bandwagon. The last time gold prices soared, back in the early 1980s, many speculative investors lost their shirts buying Krugerrands after the price of gold collapsed.
This history could prove to offer a timely lesson, as our equity analysts have tempered their previously bullish view on gold prices. Gold price behaviour and strength were very much noticeable throughout most of 2009, but prices recently began retreating in the first quarter of 2010. We think that the price pressure, along with the overwhelming interest by new retail investors over the last two years, could lead to a fall in gold prices as quickly as the rise ensued.
During the last historical gold price peak in 1982, the average investor could not wait to sell physical gold, including the family jewels. Our equity analysts think that gold prices could be range bound between $1,000 and $1,250 over the course of the next several months. However, our approach to investing in gold to establish a hedge against inflation remains unchanged. We continue to believe that only a small portion of one's portfolio should be in gold.
As a way to invest in gold as a hedge or as part of an asset-allocation strategy, investors could do worse than look at gold exchange-traded funds--ones that represent a direct investment in the underlying commodity and do not invest in equity securities or futures contracts. When considered as a long-term core holding, we would recommend using a gold ETF fund only up to a weighting of 2% of total assets, if at all. Our research suggests that a 4%-10% total weighting for all direct commodities exposure is sufficient, and the majority of that weighting should be split among energy, agricultural, and industrial and precious metals. That said, a gold ETF can be used periodically as a satellite holding as an inflation hedge or store of value during periods of currency valuation uncertainty.
This is an edited version of an article by Paul Justice, CFA, an ETF strategist with Morningstar.
