Investing November 4, 2008, 11:51PM EST

Using Gold to Diversify

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Owning gold may provide some peace of mind over the long run, but there's no consensus among analysts about what short-term path gold's price will take. Merrill Lynch's (MER) precious metals team predicts gold will hit $1,500 as government actions to end the credit crunch eventually spark inflation. J.P. Morgan (JPM) analysts think continuing turmoil in financial markets should support gold prices but predict it will trade at an average of $875 next year. At Barclays Capital, analysts reckon that a combination of a weakening dollar and a decline in hedging by gold producers will push gold to $970 by 2009's second quarter. Among the more bearish forecasters, Deutsche Bank (DB) analysts warned gold could hit $600 in the next few months and expect an average price of $750 next year because investors will continue to be more worried about deflation than inflation. And UBS (UBS) has cut its 2009 forecast to $700.

Nuggets of Safety

For investors seeking diversification, the simplest way to buy into the yellow metal is to purchase shares of an exchange-traded fund that owns gold, such as the SPDR Gold Trust (GLD). The ETFs own huge amounts of actual gold stored in vaults. The amount hit a record of almost 1,093 metric tons worldwide at the end of September, according to the World Gold Council.

But some of the most ardent gold bugs are wary of owning gold through ETFs. Concerned that elements of the financial system could break down and cripple the firms running the ETFs, they favor buying gold bullion either in coins or small bars that can be kept in a safe deposit box. Jim Cook, president of Minnesota precious metals dealer Rarity Investments, says he had his best week ever in the month of October, selling $6 million worth of coins and bars. "The financial system has created so much paper that it's becoming suspect," says Cook, who has been in the business for more than 35 years. Reputable dealers offer gold coins at a markup of only a few percentage points over the value of the gold itself. Investors should steer clear of coins being sold at huge markups.

Stocks of gold-mining companies have fallen much further than the price of gold and may offer compelling valuations. Will Danoff, manager of the $63 billion Fidelity Contrafund (FCNTX), who made a killing buying depressed gold stocks in 1999 and 2000, added shares of Goldcorp (GG) over the summer and, as of Sept. 30, had 3% of his fund in gold miners. His two biggest positions in mining outfits are Goldcorp, at 1%, and Kinross Gold (KGC), at 0.5%.

As you'd expect, mutual funds specializing in gold mining stocks have done poorly of late, with Morningstar's (MORN) precious metals category down 53% for the year. A thirst for assets probably sparked the Oct. 31 reopening of the Vanguard Precious Metals & Mining Fund (it closed in February 2006, when gold had almost reached $600). The fund is down 59% this year, trailing some 87% of its peers, but is a top performer over five- and 10-year periods.

Exaggerated Swings

Mining companies, which have fixed operating costs to get gold out of the ground, can see profits swing rapidly when the price of gold goes up or down, points out Michael Bradshaw, manager of the Evergreen Precious Metals Fund (EKWAX). So gold-mining stocks, down about 50% as a group in 2008, will see a more exaggerated gain in price from a recovery than will gold itself, he says. For example, when gold prices rose earlier in the decade from around $400 an ounce to more than $600, Goldcorp's net income shot up from $51 million in 2004 to $286 million in 2005 and $408 million in 2006. Top holdings in Bradshaw's fund, which can also own physical gold, include Kinross Gold, Rangold Resources (GOLD), and Agnico-Eagle Mines (AEM).

Whether owned as coins, through funds, or via individual stocks, gold should make up just a small slice of a portfolio. Rozanna Patane, a financial adviser in York, Me., says she will be putting a small amount—less than 5%—of her clients' assets in gold as a long-term hedge against inflation and dollar depreciation. In the short term, says Patane, "it may have some appeal as more bad news appears about profits worldwide."

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Collapsing Mining Stocks

This year's collapse in gold-mining stocks, with the Philadelphia Stock Exchange's Gold & Silver Index down 70% from March to late October, is comparable to a half-dozen similar crashes since the 1930s. Boris Sobolev of the Resource Stock Guide newsletter notes that typically the stocks hit bottom after losing about two-thirds of their value. In the wake of current turmoil, however, he thinks shares of small-cap mining companies may never recover. Sobolev writes: "Most will never see their prior peaks of glory."

To read the article, go to http://bx.businessweek.com/investing-in-commodities/reference.

Pressman is a correspondent in BusinessWeek's Boston bureau.