Investing November 4, 2008, 11:51PM EST

Using Gold to Diversify

Many investors turn to gold for security during times of market volatility. Here's the outlook for the precious metal

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Stock markets around the world have fallen off a cliff in the past month—and the price of gold, long seen as a safe haven in times of turmoil, has plummeted as well. After hitting an all-time high of more than $1,000 in March, gold dropped to $681 on Oct. 23 before bouncing back to $740 in early November. The bumpy ride has included three gold rallies—after the collapse of Bear Stearns, the seizure of Fannie Mae (FNM), and the collapse of Lehman Brothers. But each rally was followed by a sharp sell-off.

Gold's recent gyrations were caused mainly by hedge funds and other big investors desperate to raise funds to cover losses and meet creditor demands. In order to do that, they have been getting out of deals made during the past few years to buy gold and other commodities with money borrowed in Japan and the U.S. On a more fundamental level, the dollar's recent rise and the fall in the price of oil have turned off investors who buy gold when they are worried about runaway inflation as a result of higher consumer prices or a plunge in the value of the dollar.

Despite the short-term fluctuations, gold still has a role in portfolios as insurance against worst-case scenarios like a devaluation of the dollar due to spiraling government debt, argues John Hathaway, manager of the Tocqueville Gold Fund (TGLDX). While most economists have supported the government's bailout plans, the moves are likely to increase the federal debt by more than $1 trillion. The Federal Reserve isn't worried about inflation now—it's fighting off a massive bout of falling prices, or deflation, such as occurred during the Great Depression. "The Fed has created more money in the past three weeks than in the previous 28 years," Hathaway says.

Some Jumping In, Others Bailing

The crisscrossing patterns of long-term investors buying and short-termers getting out is best illustrated in the different markets where gold trades. At the Comex, where hedge funds typically buy and sell futures contracts on gold, the number of contracts in active use fell from more than 483,000 contracts in July to 319,000 in October, a 34% decline. At the same time, $2.8 billion poured into exchange-traded funds that buy gold and tend to be used for longer-term investments. Individual investors have bought so much gold directly from government mints that the U.S., Austria, and South Africa have had to suspend sales of gold coins until they can make more.

The recent moves fit with research showing that investors benefit more by holding gold over long periods to help diversify portfolios rather than moving in and out of gold only in times of stress. A review of markets around the world from 1995 to 2005 found that adding gold to a portfolio of stocks slightly improved returns with less volatility. But when the study, written by two lecturers at Trinity College Dublin, looked at gold's short-term moves around moments of crisis, they found that the benefit of buying gold ended quickly—after about two weeks. Although a variety of asset classes can help diversify portfolios, Dirk Baur, one of the study's co-authors, notes that gold's diversification benefit is strongest when the stock market is falling. Other diversifiers, like emerging markets stocks, start acting more like U.S. stocks in times of trouble.