By Gary Strom and Tony Purpero on March 2, 2012

Is gold still the safe haven for the average investor? Despite the shiny metal’s reputation as a safe investment during turbulent times, gold fell 19 percent by the end of 2011 from its September high. Although this precious metal came roaring back in January with an 11 percent gain and eclipsed the entire annual return for 2011, many experts feel it is over-valued and that investors will dump gold for stocks if the economy continues to pick up. We think investors should stick with long-term allocations rather than trying to keep up with market fluctuations and focus on the strategic role of gold in their investment portfolios.

Gold was employed over the ages as a store of financial value or a form of currency. As various forms of currency and paper monies emerged, most major economies adopted the gold standard, which fixed the value of currency to a specific amount of gold. But after World War I most countries — except the U.S. — built reserves of major currency independent of gold reserves. Finally, in 1971, the U.S. went off the gold standard altogether. Since then the price of gold has fluctuated in response to supply and demand.

Today there is an increasing demand, but jewelry only accounts for 60 to 70 percent of the annual consumption. Another 10 to 15 percent goes into industrial applications and the remaining 15 to 30 percent is held by individuals, institutions and central banks for investment purposes. Overall consumption of investable gold has quadrupled since 2001.

While supply and demand has gradually moved gold prices up over the past 10 years, there has been a rapid rise since 2007, when the first warning signs of a recession and concerns over inflation emerged. This generated a wave of demand and there was a drop in mining production. At the onset of the financial crisis of 2008 there was a sharp decline in gold prices as investors converted their investments to cash and consumption of jewelry and industrial uses decreased. However, once investors believed the U.S. banking system was not going to collapse and gold consumption in jewelry and industrial uses increased again in 2010, prices began to rise. In 2011 gold prices reached record highs, partly due to the weakness of the U.S. economy and the European debt crisis.

So, while gold’s impressive returns the past few years have not been overlooked by investors, many have seen how an allocation of this precious metal has reduced the overall volatility of an investment portfolio.
Historically, gold prices have not moved in lockstep with traditional asset classes or with most commodities other than precious metals such as silver. That makes it a great portfolio diversifier because gold behaves differently than other assets under various market conditions.

Gold has also been a good hedge against inflation and the declining value of the dollar. Since 1973 it has provided an annualized real return of 3.8 percent over the U.S. consumer price index. When the dollar declines in value the price of gold tends to rise. This is because gold is generally denominated in U.S. dollars and investors tend to purchase it to potentially protect the value of money against further price erosion.

Today, there are a variety of ways investors can access gold. They can purchase gold coins or buy gold bullion. Those who prefer not to take physical ownership can have gold accounts, invest in gold mining equities and mutual funds or use gold exchange-traded funds. Gold coins are attractive for investors wishing to invest in a relatively small amount of gold. Investors can also buy gold bullion in the form of gold bars. As with gold coins, investors should fully research prospective dealers and make certain that the gold is genuine. Gold accounts are another way to purchase a larger quantity of physical gold without the storage issues. The investor purchases a specific number of gold bars from a recognized bullion dealer or bank, which holds them in custody. Make sure to do a thorough background check on any depository you consider, whether it’s in the U.S. or not.

Gold mining stocks give investors the exposure to the price of gold through profits of producers and refiners. Profits of these companies generally rise if the price of gold rises. Gold sector mutual funds hold securities issued by miners, refiners and sellers. Passive mutual funds attempt to mirror the composition and performance of a gold sector index. Active funds select equity stocks they believe will outperform a designated index or benchmark.

Finally, gold exchange-traded funds give investors the potential benefits of owning gold without the added costs and logistics of physical ownership. ETF shares represent a proportional interest in a quantity of gold, minus expenses. An independent trust is responsible for custody, transportation, security and insurance. ETF shares are listed on an exchange and can be bought and sold through brokerage accounts during the trading day.

While adding a strategic allocation of gold to a diversified portfolio offers a number of potential benefits, investors should not overlook some of the risks either. Gold fluctuates in price just as assets do. If purchased when prices are higher and sold when they are lower, the investor loses money. Being clear about how gold moves and how it is correlated to the U.S. dollar will help to reduce this risk.

Unlike bonds or money market accounts, gold does not pay interest. If owned during a period when it is not gaining in value, or worse yet, losing value the investor loses the opportunity to earn income from investing in an alternative asset. Finally, as the price of gold has risen, so has the number of scam artists and swindlers. Be wary of gold-related investment pitches and focus on the long-term benefits of gold in your portfolio.

• By Gary Strom and Tony Purpero are co-founders of P/S Wealth Management Group in Santa Barbara. Contact them at (805) 966-1266.