Gold: No guaranteed returns

@Money January 20, 2012: 3:54 PM ET

NEW YORK (CNNMoney) -- I invested in a gold ETF over the past three months and have suffered losses. Should I hold my positions and hope for better days ahead? Or should I cut my losses now? -- S.B.

As an investment, gold can hedge against inflation, serve as a refuge in the time of economic uncertainty and generate impressive returns.

But there are also things gold can't do. It can't provide guaranteed gains, as you've discovered. And it can't act as a safe haven for your money in the sense of protecting against losses, although over the last 12 months I got emails from many people who were turning to gold for just that reason -- perceived safety in a topsy turvy financial world.

For example, someone who bought the largest gold ETF back in late August or early September got in pretty much at the peak for the year. If that person held on through the subsequent decline, as you apparently have, he or she was probably sitting on a loss of about 18% or so as of the end of the year.

On the other hand, someone who bought at the beginning of the year got in at a much lower price. Even though gold prices dropped substantially after their August-September peaks, that person still had a gain of about 10% for the year.

So when you come right down to it, investing in gold is a lot like investing in stocks. Its price can fluctuate dramatically, and whether you make or lose money depends solely on whether the price is higher when you sell than when you bought. (With stocks, of course, dividends may factor into the equation.)

In fact, based on a common measure of volatility -- standard deviation, in this case, how much prices fluctuate around their average -- the largest gold ETF was about twice as volatile as the largest Standard & Poor's 500 ETF in 2011.

With concerns about the stock market and the U.S. and foreign economies running high over the past year -- and investors eager to protect themselves from potential fallout -- I think a lot of people lost sight of this fundamental aspect of gold.

So if you're approaching gold with a trader's mentality -- that is, looking to move in and out to bag a quick gain rather than hold for the long term -- then I can't help you. I have no idea what gold prices will do in the near term, nor do I think anyone else really does.

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But if you think it's reasonable to expect that gold prices will rise over the long run -- as I do -- then one can make a case for holding a bit of gold as part of a broadly-diversified portfolio.

One good reason is while gold is very volatile, it doesn't move in synch with stock prices. It has what investment pros call a "low correlation" with the stock market.

As a practical matter, that means that owning a slug of gold (or gold ETFs or gold mutual funds) can make your portfolio less flighty overall because gold may, in effect, zig while the stocks and bonds in your portfolio zag. This won't happen all the time, but should happen enough over the long run to ease the bumpiness of your portfolio.

If you're okay with that rationale for investing in gold, then you don't need to guess about the path gold will take near-term. Instead, decide on how much of your portfolio you want to invest in gold -- I'd recommend roughly 5% to 10% -- and then maintain that percentage by buying or selling enough gold at the end of each year to get back to your target allocation.

Follow this approach, and you will end up selling some of your gold position after gold has had a run and everyone else is gaga about it -- and buying after gold prices have dipped and other investors are looking to bail out. (Under this scenario, you might very well end up buying from someone who, like you, is looking to cut his losses.) By adhering to this disciplined approach, you can reap the long-term gain gold has to offer while also reducing the volatility of your portfolio overall.

Or you can try to trade your way to profits in gold, hoping to buy before a surge and sell before a dip. In which case, my response is the same to someone who takes that tack with the stock market: Good luck with that. To top of page

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