Add luster to your portfolio

By Brendan Coffey, Fidelity Interactive Content Services — 10/22/10

You know gold is on a tear when you see ads from companies offering “cut-rate government gold” or opportunites to buy your gold jewelry.

But investors should look beyond the bizarre pitches and focus on the fundamentals. Gold shines brightest in uncertain times, and the metal hit an all-time high this month when it passed $1,350 an ounce. Consider the opportunity this trend may provide.

Some experts say gold’s rise is neither a bubble nor a harbinger of financial apocalypse, but rather a return to its rightful place as a store of wealth and a hedge against sluggish stock and bond performance.

How to invest in gold, and how much, are a matter of debate. A small allocation can go a long way: Most experts advise having no more than 5% of your portfolio, if that much, in gold. And while coins and Exchange Traded Funds (ETFs) are popular, some investment professionals say mutual funds that focus on gold miners could be most profitable for most investors.

Gold is unique in that it has acted as the sole store of wealth for centuries. The metal also has its own demand in industrial and commercial uses as well – jewelry, dentistry and in catalytic converters, for example.

Gold hit a low of about $250 an ounce in September 1999 (not adjusted for inflation), and while current prices seem high, they are well below the inflation-adjusted peak of $2,251 hit in 1980. Mindful of gold’s lows of a decade ago, the current generation of investors may be the first to largely ignore gold as a standard part of their investments.

Despite its lack of popularity with individual investors, gold has been rallying for two main reasons. One is that emerging-market economies, led by India and to a lesser extent China, have seen increasing demand as growing middle classes buy more jewelry.

Roughly half of annual demand for gold comes from jewelry, with 10% coming from industrial and dental uses and the rest from investments, such as gold coins. Of all the gold that has ever been mined, about 177,000 tons, 52% exists in the form of jewelry, 12% in industrial and dentistry form, 16% in retail investments and 2% unaccounted for.

This will be the tenth year consecutively where gold has had positive returns thanks largely to emerging market demand.

Central banks are the second main source of demand, holding 18% of the world’s mined supply. Central banks are turning to gold to diversify their holdings because the dollar, the world’s reserve currency, has been falling. Considering that central banks hold just 10% of their assets in gold, down from 80% in 1980, it’s not unreasonable that gold is flowing back into central bank holdings.

Individual investors can buy coins but that can be inefficient since you have to pay to safely store and insure your gold. You can buy bullion through the dominant gold ETF, the SPDR Gold Trust which will hold the gold for you in London.

But mutual funds that focus on owning stocks of gold mining companies rather than the metal itself may offer the best opportunity for investors, even if gold fails to rally from its record highs. That’s because miners have a cost of production of $650 an ounce, on average, meaning they will still be solidly profitable even if gold’s price falls.

But as beautiful as a bar of gold is, it doesn’t have the capacity to find more of itself, pay dividends or increase its earnings. Gold-related stocks also benefit from long-term capital gains, as low as 15% in the U.S., whereas gains from owning physical gold or a bullion-holding ETF will get taxed at the rate for collectibles, currently 28%.