Patricia Lovett-Reid

For those who follow gold, the yellow brick road has been a twisty one since the spring, but with the precious metal again trading at or near record levels, the path has become a difficult one to resist. Many investors are now asking themselves if it is time to step into the market, or whether a correction is on the way — one that might lead straight back to Kansas.

Gold is traditionally viewed as a hedge against inflation. One hundred years ago, a US$20 bill could be exchanged for one ounce of gold. Today it would take about 75 US$20 bills to do the same. The current upward trend for gold began in 2001, making it a ten-year bull run. But its sharp retreats have been just as impressive: Gold's downward price trend in the 1980s and 1990s dragged on for about 15 years.

Despite its dramatic up and down cycles, there has, in fact, been only one true "bubble" in the gold market since central banks moved off the gold standard. In early 1980, the price of gold hit a record high of US$850 an ounce, up from around US$319 only five months earlier. Prices then proceeded to plunge, eventually dropping to US$296.75 an ounce on June 21, 1982.

Many investors fear they could be caught in another bubble, but Satish Rai, chief investment officer with TD Asset Management looks at gold differently. He says gold's current trading level is a reflection of investors' concerns about sovereign debt issues. You might expect growing fears about the European sovereign debt crisis to send people to the safety of the U.S. dollar, but with American debt levels passing $14 trillion, investors are instead heading into the arms of other investments, including gold.

Adding gold to your portfolio nugget by nugget
One way to buy gold as an insurance against financial market uncertainties is to add one per cent to your portfolio every month for a year. That will give you a weighting of about 10 - 12 per cent in gold. It's not a bad strategy if you believe there is still plenty of debt and U.S. dollar risk to guard against.

But there are reasons to limit your weighting in gold. The demand for bullion may start to ease once financial conditions become more stable. Gold does not provide an income stream, and returns are dependent on capital appreciation. In comparison, blue-chip dividend-paying equities are able to generate capital gains over the long-term in addition to a regular stream of dividend income.

Over the past 25 years ending June 30, 2011, the S&P TSX Composite has earned an average annual total return of 8.66 per cent and the S&P 500 has earned 7.79 per cent in Canadian dollars. Over the same period, gold has earned 4.55 per cent per year in Canadian dollars. Looking at it another way, over the past 25 years, $1,000 invested would have grown as follows:

  • in the S&P / TSX Composite = $7,975
  • in the S&P 500 = $6,523
  • in gold = $3,038

Ways to include gold in your investments

  • Physical bullion vs. gold stocks

    When you buy gold, you have a direct relationship with the price of the metal. If the price of gold rises, you profit (and vice versa). You don't have to worry about the quality of management or operational costs of the gold miners.

    When you invest in gold stocks however, the price of the stock isn't perfectly correlated to the price of gold. That's because, in a sense, you are making two investments in one. The price of the stock is made up of the gold that the company has or is producing and the value of the gold that the company may have. In other words, you are investing in production and exploration.
  • Precious metal mutual funds

    These may differ in their structure — some may invest simply in the shares of gold mining companies, some may invest in companies that mine precious minerals other than gold and some may invest partly in gold stocks and partly in the underlying metal.
  • Gold metal ETFs

    Exchange-traded funds are for those who want exposure to gold, but do not want the bother of safe-keeping. Among ETFs to consider, the "Spider" Gold Trust — the most actively traded precious metal ETF, which holds physical gold bullion. There are even ETFs which hold gold in vaults located specifically in Asia, or Switzerland, among other places. Some gold ETFs invest in gold futures rather than the physical metal.

This summer, with economic uncertainty again front and centre in the U.S. and Europe, a walk down the yellow brick road might be worth exploring.