This week, Gails explains that a little gold can make your portfolio shine.

Hi, Gail —

What’s up with gold? The price seems to have soared this year. Is that because higher oil prices are triggering higher inflation? My brother just invested in some gold because he’s convinced it’s going to hit $800/ounce like it did years ago. My husband and I have some extra money and are wondering if we ought to buy some gold, too.

Thanks,

Sharon

Dear Sharon —

Don’t invest in gold because you hope to sell in a few months and make a killing. Over the years, trying to predict the price of this precious metal has proven to be an exercise in frustration.

However, owning gold as part of your long-term investment strategy makes sense, as I explain below.

Putting it in Perspective

First, let me set the record straight. Gold started this year at just under $440/ounce. It bounced around between $415-440 until the end of August. It touched $468 in September and then really took off in mid-November, hitting $540 on Dec. 12 — a gain of 23 percent on the year.

That’s what is grabbing all of the headlines. But it’s important to put this in perspective: it’s taken almost 25 years for the price of gold to get where it is today.

Gold’s all-time high price of $850 was reached in January 1980. Between then and now “there’s been a whole lot of disappointment,” says Bill Martin, who runs the “American Century Global Gold” fund. Adjusted for inflation, gold would have to hit $2,500/ounce for today’s price to be comparable to what it was selling for in 1980!

When gold touched $540/ounce earlier this month, it was partly attributed to “aggressive Japanese buying.” Five days later it was down to $508 and the pundits were proclaiming it was partly due to (can you guess?) “heavy selling in Japan!”

The point is, since gold is an element that exists in a relatively small quantity worldwide, actions over which you have no control can result in sharp price swings. Because of this, professionals caution that you should not commit more than 5 percent of your total investment portfolio to gold, or to a diversified basket of commodities that would include precious metals, oil, and other natural resources.

The Inflation Factor

Most people associate an increase in the price of gold with an increase in inflation. You may be thinking, “Gee, look what I’m paying for gas and to heat my house. Inflation is back!”

Whoa, cowboy! Yes, energy prices are higher, but at an annualized inflation rate of about 2 ½ percent, we’re nowhere close to the runaway, double-digit inflation we experienced in the 1970s and early 1980s. In fact, we’re below the average inflation rate of 3½ percent Americans saw during most of the 20th century.

David Joy, Chief Market Strategist at RiverSource Investments, a division of Ameriprise Financial, says, “We don’t expect inflation to be a problem.” Moreover, he adds that it’s not surprising to see an increase in inflation at this late stage of the economic cycle with unemployment running around 5 percent (historically low), unit labor costs rising, and capacity utilization (a measure of the nation’s production capabilities) high.

According to Alan Skrainka, general partner and Head of Research at Edward Jones, if you’re worried about inflation, “a better hedge is a money market account. You’ll earn a higher return on your short-term investments.” He also likes TIPS, or Treasury Inflation-Protected Securities whose return is periodically adjusted based on the consumer price index.

But, frankly, none of the professionals I spoke with is overly concerned about inflation.

Declining Dollar Worries

A bigger worry is the possibility that the dollar could lose value relative to other currencies. The reason? Our Kong-sized twin deficits: federal and trade.

Like commodities such as gold, there is a limited quantity of U.S. dollars in the global markets. Both assets respond to supply and demand. If demand is steady, increasing the supply reduces their value. Unlike gold, which Mother Nature has limited to a finite amount, if Uncle Sam wants more dollars, he can simply turn on the printing presses or add dollars to the monetary system through the Federal Reserve Bank.

Increasing the amount of dollars in circulation would depress their value. As a result, you’d need more dollars to buy the same amount of goods and services. Voila: inflation.

Larry Martin (no relationship to American Century’s Bill Martin), a self-taught gold bug who publishes a newsletter at http://www.eaglewing.com , maintains it was no coincidence that the price of gold rose $35 in September. “After Hurricane Katrina the federal government promised to help cover the hurricane costs up to $100 billion. Many investors saw this as a lack of budgetary discipline by the Bush administration.” Not to mention the expensive Medicare drug benefit just introduced and the looming bailout for Social Security.

Translation: worries that government spending could lead to inflation leads people to put their faith in “hard” assets instead of currency. Incidentally, the other two major world currencies — the yen and euro — are also showing signs of weakness.

But a more immediate worry is the record U.S. trade deficit, which reached almost $69 billion in October. Our appetite for foreign imports “means there are more dollars overseas,” says portfolio manager Bill Martin. If holders of dollars are uncertain about whether the currency will maintain its value, “they don’t want to invest back in the U.S., so they buy gold.”

November’s Double-Whammy

Two unrelated events may have sparked the gold rally that started in November: 1) rumors that the central banks of Russia, Argentina, and South Africa might – might — increase their gold reserves and 2) the naming of Ben Bernanke as the new Chairman of the Federal Reserve Bank.

American Century’s Bill Martin points out that there may be a clever strategy motivating those three countries hinting about buying gold for their central banks: “These are all producers of gold. A higher gold price would help these countries.” Whether they actually increased their reserves or not.

The Bernanke angle probably carries more weight. The Chairman of the Federal Reserve Bank is the most powerful individual in the global financial markets. Investors, who have gotten used to Alan Greenspan over the past 18 years, are justifiably nervous about what his predecessor’s policies will be. When he takes over next year will Bernanke favor growth over containing inflation? Does he favor a strong dollar?

Back in 2002, when Bernanke was simply a “governor” on the Federal Reserve Board and the worry was not inflation, but deflation (steadily falling prices a la the Great Depression), he suggested one way to stimulate the economy would be to “throw money out of helicopters.”

Dollar-watchers wonder whether that tongue-in-cheek remark has an element of truth to it. They worry that as Fed Chairman, Bernanke might sacrifice the value of the dollar to jump-start the U.S. economy.

The Bling, Bling Factor

Unlike platinum and other metals, there is very little industrial use for gold. It’s mainly used in jewelry.

RiverSource’s Joy says, “We’re seeing a lot of demand for jewelry,” with much of that coming from Asia and the Middle East.

But American Century’s Bill Martin refutes that. He points out that according to the World Gold Council, the organization which represents gold producers, while total world demand for gold out-paced supply last year, the situation has begun to reverse itself this year, with supply exceeding demand in two of the past three quarters.

Will Gold Lose Its Luster?

That’s a big reason he thinks this rally is going to lose some steam. “I don’t think people are looking at the supply side. “It’s increasing. People forget that this will happen when the price goes up.” That’s because as the price of gold climbs, mining companies have an incentive to go after the metal in “areas that weren’t economically feasible before.”

As additional supply comes on the market, the price of gold will subside.

Why Gold Can Shine in Your Portfolio

None-the-less, both Joy and Skrainka say having some exposure to gold in your portfolio makes sense, as long as you recognize the role it can play. “Gold is a fairly non-correlated assets compared to stocks and bonds,” says RiverSource’s Joy. “It will give you some volatility reduction under most circumstances.”

In other words, gold tends to “zig” when other assets, particularly stocks, “zag.” Thus, it dampens the fluctuations in the value of your portfolio.

According to American Century’s Martin, “Gold is a fabulous insurance policy.” “It tends to do well when other assets don’t.” He says it’s especially important for a retiree’s portfolio because “it smooths the ride.”

“Our advice is that for a very small portion of your portfolio — 5 percent — it’s OK to own gold or a broader basket of commodities,” says Edward Jones’ Skrainka. “But don’t do this because it’s popular or exciting. If you’re investing in gold, you need to stay committed through good times and bad.”

In other words, don’t buy gold with the idea of turning a quick profit. The only ones who get rich in that scenario are brokers and commodities dealers.

Skrainka thinks “maybe the best way to invest in gold is through a mutual fund.” You can also get exposure to commodities through Exchange Traded Funds, or EFTs. Skrainka likes “ETFs that track the Australian and Canadian markets because they’re resource-based economies. They’ve been selling to the Chinese.”

Ponder This

I leave you with the following observation of Bill Martin, who has been managing the American Century Global Gold fund for 13 years:

“Over the long-term gold goes up with inflation. Sometimes it runs up in advance. Sometimes it crashes hard. Gold’s going to give you a lot of head-fakes.”

Happy Holidays,

Gail

If you have a question for Gail Buckner and the Your $ Matters column, send them to yourmoneymatters@gmail.com , along with your name and phone number.