What Happened to Gold's Luster?

Gold prices were very volatile last week, declining 13% over two days before rebounding at the end of the week. Overall, the price of gold has slid approximately 20% in recent months to close near $1,400 per ounce at the end of the week. What is happening to gold prices?

The simple answer is there are more sellers recently than buyers. Underlying that simple answer are several other potential factors:

• It is rumored that at least one large financial institution recently initiated large short sales of gold bullion betting the price would decline. An order of this magnitude tends to spook the market and start a wave of selling.

• China is reporting slower projected economic growth, which could result in lower levels of gold purchases by Chinese investors.

• There has been speculation that some economically troubled counties in Europe may be forced to sell their gold reserves to secure future EU bailouts.

• Many financial managers have concluded recently that inflation is in check and are reducing their client’s exposure to gold.

• When gold prices declined recently many gold commodities traders headed for the exits as they tend to trade on short-term events and are not willing to hold a losing position for any length of time.

I think gold has a small place in investor’s portfolios, mainly as an inflation hedge and diversification tool. Since the U.S. dollar was uncoupled from gold in the early 1970s, gold has done well historically in preserving the purchasing power of capital over time against the ravages of inflation. In my opinion gold should continue to do so in the long run.

Unfortunately, over the near term, gold can be very volatile. If anything, if you do not have gold in your portfolio, the recent price decline may provide a buying opportunity to add some to your portfolio.

On the flip side, Warren Buffet abhors gold as an investment simply because it does not generate any economic activity in and of itself. I have read estimates suggesting that all the gold in the world would fill several football fields several hundred feet thick. Buffet’s argument is that in 20 years the gold will still fill the same space and will not have generated any economic activity or income. In other words, the quantity of gold will not have increases (excluding new mining production) over the 20 years and it will have not created jobs, income, etc., over that time frame like a successful business enterprise would do.

Buffet’s views support my belief that gold should not be a major part of your investment portfolio — its historic function has been to act solely as an insurance policy against inflation for a portion of your assets (unless of course you wear it as jewelry).

If you find gold attractive as a potential inflation hedge, you can talk to your regular financial advisor on how best to own gold in your portfolio. If your objective is to use gold solely as a vehicle to try and hedge a small part of your assets against long-term inflation, I advise you invest in a fund that actually owns real gold bullion.

Another option for owning gold is to own rare gold coins. Rare gold coins have some interesting investment features. First there is the actual value of the gold in the coin. Second, gold coins also have intrinsic value due to the fact that there is a limited supply of old collectible gold coins — you cannot create more of them (watch out for forgeries, of course). Third, the market for collectible gold coins is relatively liquid — you can turn them into cash in a short time frame. Although subject to short-term price volatility, rare gold coins have also provided a good hedge against inflation.

Finally, collectible gold coins present some interesting tax planning, estate planning and asset protection planning aspects. The key is to work with a reputable rare coin dealer. I collect wine and the same issues arise with buying collectible wine — working with a reputable merchant. If you don’t know a reputable rare coin dealer, I can refer you to several with long-term reputations for high levels of integrity.

David Dyer is a licensed tax attorney and owner of Alliance Affiliated Equities Corporation, a FINRA registered Broker/Dealer specializing in real asset investments such as oil and gas well, cell phone towers, residential rental income properties and assisted living properties. He invites questions or comments at dave@aaeconline.com (ph. 913-428-8278).