The Gold Frenzy: Why Investors Should Resist

The price of gold hit record highs over the week of May 10-14, attracting the attention of many retail investors. But this precious metal is no safe haven.

As an investment, gold has never been more popular. And, for individual investors, that's part of the problem.

Encouraged by TV and radio ads touting the virtues of gold, retail investors are buying it up. One leading gold dealer, Goldline International, estimates it has added 50,000 clients in the past three years. The gold frenzy is worldwide: On May 13, a vending machine that dispenses gold bars was unveiled at Abu Dhabi's Emirates Palace hotel.

Financial experts warn that all this enthusiasm for gold could be a warning sign -- that gold prices could be near their peak. "It's very in vogue right now, which is usually a telltale sign [of] a bubble-like mentality," says James Miller, president of Woodward Financial Advisors in Chapel Hill, N.C.

Gold's advocates may be right that the metal could head higher still, driven by the fiscal crisis in Europe, high deficits in the U.S., and fears of inflation. "All we can do is put our money into real assets, because paper money everywhere is being debased," Jim Rogers, chairman of Rogers Holdings, told Bloomberg Television on May 12 as gold hit new highs.

Treacherous Field

But even if gold keeps rising -- a prospect very difficult to predict, given the metal's volatile track record -- there are several features of gold that make it treacherous for individual investors, financial advisers say.

Gold might have a reputation as a "safe haven," but nothing could be further from the truth, says Susan C. Elser, of Elser Financial Planning in Indianapolis. Unlike other commodities, gold has few industrial uses. Unlike businesses owned through the stock market, gold earns no profits and doesn't pay out dividends. Unlike bonds, no one pays interest to holders of gold. And, unlike insured bank deposits, there is no guarantee of your principal investment.

"There is no downside protection on investing in gold," Elser says.

Gold used to be the backing for currencies, but no longer. Now "it really is only a store of value because people say it's a store of value," says Ken Eaton, principal at Stepp & Rothwell, a financial planning firm in Overland Park, Kan. That can lead to extreme volatility, which financial planners cite as one of gold's biggest downsides.

Gold may be up 84 percent in three years, but it has taken a wild path to get there. Most recently, gold fell 12.6 percent from Dec. 2 to Feb. 8, then rebounded 16 percent in the next three months.

Much of gold's appeal is built on its use as protection against inflation, which some -- but not all -- investors see as a potential threat.

"We're in very unusual times," says Barbara Camaglia, head of Legacy Financial Advisors in Beachwood, Ohio. "Everyone is debasing their currencies, so I think having some gold is not a bad idea."

Portfolio Allocation

Gold is just one part of a diverse portfolio, she says, with a portfolio allocation often kept to 5 percent, though "you could argue for a higher percentage." A small gold holding is typically recommended even by financial planners, like Eaton, who are skeptical of buying gold now. Gold is one sliver of commodity holdings that make up 2.5 percent to 5 percent of his clients' portfolios, Eaton says.

It's true that gold kept pace with inflation in the 1970s. The annual increase in the consumer price index averaged 9.3 percent from 1973 through 1981. The market price of gold at the end of 1972 was $63.91, rising to $456.90 by the end of 1982. That's a 615 percent increase, compared to cumulative inflation from 1972 to 1983 of 138 percent.

However, gold's record as an inflation hedge is more mixed over the long term. Because gold fell from 1980 to 2001, the metal's total appreciation from 1972 to 2001 was just 336.5 percent. That barely beats inflation over those 29 years of 323.7 percent, and is way behind the 2,466 percent return of the broad Standard & Poor's 500-stock index if dividends are included.

"There are [short] periods of time -- like now and the 1970s -- when there is really a lot of uncertainty out there, and people flock to [gold] for safety," says Miller of Woodward Financial Advisors. But gold's long-term record is weak, he adds. "It's a short-term trading vehicle rather than a long-term investment."

There are practical problems with owning gold, as well. It's heavy, and not easy for the average investor to buy, sell, ship, and store. "You're dealing with a lot more transactional costs," says David Lamp, a financial planner at BBJS Financial Advisors in Seattle. He keeps no more than 1 percent or 2 percent of client portfolios in gold.

Goldline's Profile

One easier way to get exposure to gold is through exchange-traded funds. For example, the SPDR Gold Trust (NYSE: GLD - News) holds actual gold bullion. The PowerShares DB Gold Fund (NYSE: DGL - News) holds futures contracts linked to the price of gold, and the Market Vectors Gold Miners ETF (NYSE: GDX - News) holds stock in gold mining companies.

Many gold investors, however, don't trust funds to hold their gold. The vast majority of Goldline customers want their gold physically delivered to their homes, says Goldline Executive Vice-President Scott Carter.

The company, which nets about $500 million in revenue each year, touts the endorsements of conservative pundits Glenn Beck, Laura Ingraham, and Mark Levin, as well as former Arkansas governor and Republican Presidential candidate Mike Huckabee. The average initial customer at Goldline invests $15,000 to $25,000, and Carter says Goldline discourages "the speculator," recommending holding gold for three to five years and only as 5 percent to 15 percent of a diversified investment strategy.

The transaction costs of gold are reflected in Goldline's prices. To buy from Goldline, gold bullion sells for about 5 percent above the current market price, while special gold coins can get markups of up to 35 percent. Selling back to Goldline, customers typically pay 2 percent below the market price, Carter says.

For many investors, however, the appeal of gold, especially in its physical form, remains strong.

"They don't want a piece of paper," Carter says. "You're buying something you can see and touch. There is a large group of investors who like to buy physical, tangible assets."

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