Some Would-Be Gold Bugs Need to Be Aware of Past Volatility

Posted: Apr 18, 2006 2:45 PM

Over the years, my experience with gold has been extremely limited. Except for the gold wedding band I've worn for 21 years, my only significant encounter with the precious metal occurred in the late 1990s, when my husband and I received an insured package in the mail that contained two gold coins.

My father-in-law had sent us the coins as his contribution to our son's college fund. The gold coins, which were each protected in a thin plastic case, were shiny and beautifully engraved.

But what I found most amazing about these diminutive coins was how they had killed off my father-in-law's enthusiasm for gold. The coins weren't numismatic marvels; they were mutts. In fact, when I learned how much my father-in-law had paid for the coins and what they were now worth, I was stunned. After calling rare coin dealers, I unloaded the gift and sunk the proceeds into a mutual fund.

I recalled my brief brush with gold because of what's been happening to the precious metal lately. Gold hit a 25-year peak a few days ago. In just the final week of March, gold-oriented mutual funds soared 9.99 percent.

Inevitably, the phenomenal performance has attracted the attention of many of the nation's most incompetent investors. These are the folks who only start salivating about an investment when there's a good chance - unbeknownst to them - that they will lose money. When the hot investment they are chasing inevitably hits a pothole, these investors will quickly leave the scene and steer their tattered portfolio to the next "winner." There's a term for this sad behavior: "Buy high and sell low."

With Wall Street now crawling with gold bugs, it's important that you understand a bit of history about gold investments before you contemplate joining them.

It's easy to trace the precious metal's footprints by looking at statistics compiled by Kenneth R. French, a professor of finance at Dartmouth College, who is at the top of the academic food chain of business school academics. French's performance figures for precious metal stocks date to July 1963. From that period to the end of 2004, these stocks generated a yearly return of 9.21 percent. In comparison, the blue chips in the Standard & Poor's 500 Index and long-term U.S. Treasuries returned 10.74 percent and 7.53 percent annually. So, congratulations gold. You've proven you can play with the big boys.

But these long-term figures hide some irritating traits. Gold can behave like a balky child, who won't budge from the grocery checkout aisle until you buy her a box of Skittles. In fact, this asset class can exasperate investors for much longer than a forgotten temper tantrum.

In French's database, precious metal stocks have dropped more than 35 percent five different times. What's more, the stocks once free fell nearly 70 percent. And this ought to make you hesitate: During a period between October 1980 to August 1998, gold's annualized return was a negative 4.2 percent. That's a long time to wait for a profit.

After digesting those figures, you may appreciate this admonition: If your motivation for clearing a space in your portfolio for gold is because you're mesmerized by its recent glittering returns, drop the shovel. If you pile gold into your investment account with that sort of mind-set, you will almost certainly bail when the luster fades, which ranks right up there in terms of destructive behavior.

Undoubtedly, the best reason to buy gold is this: It represents a solid way to diversify. Ideally, your portfolio should contain asset classes that don't behave the same. And gold's correlation to most of the world's equities is quite small, which is what you want. Gold investments can also prosper during times of inflation.

You should, however, tie up only 1 percent to 5 percent of your holdings in this volatile asset class - if you want to include it at all - and then you should just hang onto it. You'd only need to touch it when rebalancing your portfolio.

Unfortunately, gold enthusiasts will discover few decent investing alternatives. Buying gold bullion or coins, as my father-in-law did, is definitely a nonstarter.

"The metal itself throws off no income, has zero long-term return and has storage costs," says William Bernstein, an investment adviser and the author of "The Four Pillars of Investing" (McGraw-Hill; 430) and "The Intelligent Asset Allocator" (McGraw-Hill; $30), which are highly acclaimed financial books.

And those are the reasons why Bernstein cautions against investing in the fairly new gold exchange-traded funds, iShares COMEX Gold (stock ticker: IAU) and streetTRACKS Gold Shares (ticker: GLD). These ETFs invest in gold, not gold stocks. What's more, because the gold in these funds are considered "collectibles," any long-term capital gains will be taxed at a whopping 28 percent instead of the maximum long-term capital gains rate of 15 percent that stocks and mutual funds enjoy.

The remaining alternative is finding a mutual fund that invests in gold and other precious metal stocks. The only one Bernstein favors is Vanguard Precious Metals and Mining Fund because of its reasonable expenses. Vanguard, however, closed the fund to new investors in February after too many impulsive knuckleheads piled into the fund for all the wrong reasons. When shopping for a precious metals fund, stay away from funds that charge a sales commission and pass along high expenses.

What's in store for gold in the future? "I can't tell you how much further or longer this asset class has to run," Bernstein wrote in a recent commentary. "Maybe a decade, maybe two, or maybe 10 minutes. But I can tell you the disenchantment that will follow the inevitable next period of underperformance will make the flight from tech stocks in the 1990s look like an infant's post-bottle burp."