Investing In Gold: Why Not To Have Gold In Your Portfolio

SmartMoney:

After sliding 6% in May, the price of gold jumped 3.7% on Friday. Skeptics say it is a temporary rise in a longer downturn. Fans of the metal say it is the start of another glorious run.

Picking a side is pointless. Gold defies efforts to calculate its worth -- or even to describe how it behaves as an investment. That means there isn't a clear reason to invest in it.

If you must own some gold to sleep better, stick with a multivitamin approach: A little bit won't hurt. A lot can prove toxic.

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Gold is prone to long booms and busts. Before its latest dip, it multiplied five times in value over a decade, mocking stocks and other investments. Before that, it lost money for 20 years.

Some investors look to gold as a safe haven. It is one -- but only when it wants to be. Just over two years ago, when investors learned that Greece's deficits were much larger than officials there had reported, the metal followed U.S. Treasurys higher while Greek government bonds crashed.

Yet last month, with Greece's fiscal crisis intensifying, Greek government bonds again tumbled while U.S. Treasurys rose, but this time investors dumped gold.

To study how gold behaves, we asked FactSet Research Systems to analyze the metal's short-term correlation with two other investments: the 10-year Treasury note, representing safe havens, and the Standard & Poor's 500 stock index, representing risk.

"Correlation" is a measure of how closely two assets track each other. A reading of 1.0 means they trade in lock-step, while zero means they are independent and a reading of minus-1.0 means they act like opposites.

What did FactSet find? Chaos. The correlation between gold and the 10-year Treasury has jumped above 0.6 at some points over the past five years and has fallen below minus-0.8 during others, changing direction several times. The one between gold and stocks has had similar spasms, with the highs topping 0.9.

In other words, gold might suffer from a multiple personality disorder.

Some investors say gold is a hedge against inflation. That is true of any good or service that consumers can be counted on to want in coming years, such as oil or poultry farms. Gold's wild swings have made it a poor proxy for the consumer-price index, a key inflation measure.

Perhaps that is because only 12% of gold's demand comes from industrial applications, according to the World Gold Council, a trade group. The rest comes from jewelry and investment (and the divide between those two isn't always clear).

Still others view gold as "real money" -- the one thing that will hold its value if governments create so much new currency that those currencies lose their value. Taken to its logical conclusion, this means governments would eventually agree to once again use gold as the basis for their currencies, says James Swanson, chief investment strategist at MFS, a mutual-fund company.

That is a fantasy, he argues, because some powerful nations have relatively little gold and some gold-rich nations have little power.

So how much is gold really worth? With stocks, bonds, rental houses and Laundromats, one way to answer that question is to compare the purchase price with expected cash flow. But gold doesn't generate any cash. Indeed, it costs something to store it.

Investors sometimes use the cost of producing the world's next ounce of gold as an approximate floor for its price. That cost is between $1,200 and $1,400 now, depending on the efficiency of the mine, reckons Michael Dudas, a mining-stock analyst at investment bank Sterne Agee. Gold sold for $1,620.50 an ounce on Friday.

There is a catch, however: The cost of mining gold has followed the price of gold higher, as mining firms have bid up machine prices and countries with plenty of gold underground have raised the royalties they charge to miners, Mr. Dudas says. If production costs are a floor for gold's price, the floor is made of straw, not concrete.

Of course, gold's price is ultimately based on supply and demand, and demand has surely soared over the past decade. Exchange-traded funds such as SPDR Gold Shares and iShares Gold Trust have made gold investing easier than ever. Gold-coin pitchmen have played off the angst and distrust left by a global financial crisis.

But ultimately, as Mr. Swanson puts it, you need a psychology book rather than a calculator to decide how to trade gold, and that means you shouldn't rely on it to do anything specific.

Investors who are determined to stock up on gold following May's dip might wish to give gold stocks a look instead. Year to date, gold's price is up 3.5%, but the Market Vectors Gold Miners ETF has fallen 9.4%.

Adrian Day, an Annapolis, Md., money manager overseeing $170 million, says gold miners look unusually cheap relative to the size of their gold reserves. Joseph Foster, manager of the Van Eck International Investors Gold fund, can place fund assets in either gold or mining shares. He says he heavily favors the latter now.

Mr. Foster's top holdings include Randgold Resources and New Gold. Sterne Agee's Mr. Dudas issued buy recommendations on Newmont Mining and Gold Resource last month.

For investors who won't feel comfortable without having some physical gold within easy reach, one last piece of advice: Forget about Krugerrands. Buy your spouse something expensive, lovely and high-carat.

That way, even if gold disappoints, at least someone will be happy.

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