Going for the Gold

Resurgent gold prices have rekindled interest in the metal, but investing in gold has unique risks.

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Although the pirates of old weren't known for their financial wisdom, recent economic trends have rekindled interest in an investment vehicle that these swashbuckling seagoers would certainly have recommended: gold.

Gold prices have risen about 26 percent this year, to just under $800 an ounce, after having more than tripled since 2001. And with many analysts predicting that prices will climb even farther, investing in the precious yellow metal—through bullion itself, gold exchange-traded funds, mining company stocks, or precious metal funds—has become increasingly appealing. "I have told our gang for six years that every account ought to have a minimum of 3 percent [exposure to gold]," says Jeffrey Saut, the chief investment strategist at Raymond James & Associates.

But investing in gold—a physical commodity—differs significantly from investing in purely financial assets such stocks and bonds, and if you're considering getting into gold, you should make sure you understand its unique properties and risks.

History: Stretching back thousands of years, gold has served as the yardstick of wealth for everyone from Egyptian pharaohs to medieval kings. As world governments began using gold to back their currencies, it played a key role in the global financial system well into the 20th century. The United States remained on the gold standard until 1971, when President Nixon suspended the convertibility of gold into U.S. dollars.

Because it's a hard asset that doesn't depend on the promise of an issuer—as with a fiat currency like the dollar—gold has the welcome ability to retain its value when other investment classes flounder. The price of gold tends to rise during periods of inflation or geopolitical tension—such as the late 1970s—as investors move money from stocks and bonds to the relative stability of gold. As such, gold has long been considered a "safe haven" for investors. At the same time, it has inspired an almost cultlike following of economists and investors—known as gold bugs—who perceive rising gold prices as an apocalyptic harbinger of hyperinflation or economic calamity.

Investment risks and rewards: Anyone considering investing in gold—whether it's through a gold ETF or a mining company stock—must be willing to accept the risks associated with this historically volatile commodity. The price of gold tumbled nearly 70 percent from 1980 to 2001, creating a two-decade-long bear market for gold investors. Still, Carlos Sanchez, a precious-metals analyst at CPM Group, expects the price of gold to keep increasing over the next couple of quarters and break the $900 mark sometime next year. "If you can stomach the volatility, I think this is something for you," Sanchez says.

Investors should also understand the role of gold investment products in a portfolio. Because it can retain value over time and moves inversely with the U.S. dollar, gold is best thought of as a measure of diversity to help stabilize a portfolio from the volatility of inflation or geopolitical crises. As such, gold should be used to complement—rather than replace—traditional equities and should make up only about 5 percent of an investor's holdings. "It makes a lot of sense within a diversified portfolio," says Steve Land, a portfolio manager for Franklin Templeton's Gold and Precious Metals Fund.

But despite its potential benefits, gold's limitations must be kept in mind. Among them: "When it comes to buying rings, women still prefer diamonds," says Arieh Coll, the portfolio manager of Eaton Vance's Tax-Managed Multi-Cap Growth Fund, which has some exposure to gold.