The Risks and Rewards of Owning Gold

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Gold prices have soared in recent years, rising from $271 an ounce in 2001 to more than $1,000 recently. Seeing the gains, plenty of investors have been racing to buy gold bullion and precious metals mutual funds. Should you join the crowd? Perhaps. But before taking the plunge, consider the risks of owning precious metals.

While plenty of analysts think that gold will keep rising, it is notoriously difficult to predict the direction of gold prices. After peaking at $850 in January 1980, gold spent most of the next two decades below $500. Gold often moves erratically, rising sharply and then falling hard.

Whether or not prices continue soaring, it can make sense to put 3% to 5% of your portfolio in precious metals. For starters, gold acts as an insurance policy. Though prices may bounce up and down, gold has always held some value. Analysts say that over the decades an ounce of gold has typically been worth about as much as a good man's suit. In contrast, the price of a stock can drop to zero.

In addition, gold can help to diversify a portfolio because it sometimes rises when stocks falls. During the past five years, precious metals mutual funds returned 18% annually, compared to 0.6% for the S&P 500.

While the S&P 500 tends to rise during periods of prosperity, gold can soar in good and bad times. During recessions, investors sometimes flock to gold for the protection it provides. In years when the economy is expanding, investors have less interest in gold, but prices can still remain firm because of demand for jewelry.

Gold does best during periods when Washington is running a big budget deficit, says Frank Holmes, a portfolio manager of U.S. Global Investors Gold and Precious Metals Fund. Deficit spending can lead to inflation, a menace that causes investors to seek shelter in gold. During the 1990s, the United States ran a budget surplus, and gold funds lagged the S&P 500. Since then, gold climbed as the deficit exploded.

Bullion or mining stocks?

To own gold, you can buy coins or bullion from a dealer. That can be expensive and cumbersome because you must pay brokerage commissions and store the precious metal in a safety deposit box. A more convenient approach is to use funds that either hold bullion or mining stocks.

Mining stocks are the more volatile choice, rising steeply when gold climbs—and falling sharply when prices dip. To understand why the stocks can bounce abruptly, consider that it currently costs some companies about $500 to produce an ounce of gold that now sells for $1,000. If the price of bullion climbs 10% to $1,100, mining profit margins would climb 20% as operating earnings rise from $500 to $600. When bullion prices fall, the process reverses. Margins narrow sharply, and the stocks can collapse.   

For diversification, consider holding both stocks and bullion. Say you decide to put 3% of assets in gold. Divide the position equally between bullion and stocks. If mining stocks soar, trim the position back to your target allocation.

To hold bullion, you can use an exchange-traded fund, such as SPDR Gold Shares. This trades on exchanges like any stock. The fund keeps 32 million ounces of bullion in a vault a London. If you buy a share in the fund, you own about 1/10 of an ounce. To purchase shares in the fund, you must go through a stockbroker and pay the same commission that is charged for any trade. The fund also imposes an annual expense ratio of 0.42%.

Diversified gold funds

To own mining stocks, consider buying into a gold mutual fund. These funds hold diversified collections of mining companies from around the world. A top choice is Franklin Gold and Precious Metals Fund, which returned 23% annually over the past five years.

Franklin portfolio manager Steve Land focuses on large companies with long track records for producing gold profitably. He sticks with mines that have low production costs because they have higher profit margins. A big holding is Randgold Resources, which has operations in Mali and other African countries. Another holding is AngloGold Ashanti, a South African producer.

To hold a limited gold stake, consider Permanent Portfolio, a mutual fund. Designed to protect assets under any market conditions, the fund always keeps 20% of assets in gold bullion. The rest of the portfolio includes 5% in silver, 35% in Treasuries, 10% in Swiss francs, 15% in real estate and natural resources stocks, and 15% in growth stocks. 

The strategy has worked brilliantly in recent years, enabling the fund to avoid big losses in downturns while recording decent returns in better times. During the past decade, Permanent Portfolio has returned 9.4% annually, outdoing the S&P 500 by 10 percentage points.

Another solid choice is First Eagle Global, a fund that holds a mix of gold, bonds and stocks. During the past decade, First Eagle has returned 13% annually. The fund typically has 5% to 10% of assets in a mix of bullion and gold-mining stocks. Recently, First Eagle has raised its gold position to 12%. Fund manager Abhay Deshpande is becoming more cautious because he fears that the global financial problems can continue taking a toll for years.

First Eagle favors mining stocks that trade for less than the value of their gold reserves. Holdings include Lihir Gold, which has mines in New Guineau, and Gold Fields, a South African producer.

Another fund with a gold stake is IVA International, which has 6% of assets in bullion. Portfolio manager Charles de Vaulx says gold can offer some protection at a time when it is unclear whether the Federal Reserve will rescue the economy or create inflationary problems.

Worried that the global economy could be headed for a period of poor performance, de Vaulx has put most of his portfolio in precious metals and fixed income. He only has 40% of assets in stocks, a small stake for a fund that normally keeps most of its holdings in equities. If stocks skyrocket, IVA will lag the market. But the fund's defensive posture will protect shareholders if stocks suddenly fall.

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