A Golden Hedge

12/30/2005 12:00 am EST

Focus:

Keith Fitz-Gerald

Editor, High Velocity Profits and Total Wealth

"Though bonds are a great income-producing tool and our bond holdings have done a great job for us, we’ve got to be conscious of how inflation and rising rates affect them," notes Keith Fitz-Gerald, editor of The Skeptical Investor. Here, he looks at gold as an inflation hedge.

"As rates rise, bond prices fall, and that means your principal is at risk. One of the best ways to hedge the risk of rising rates and boost profits is with gold. The beauty of yellow metal is that it shines in inflationary climates. That’s why I want you to add StreetTracks Gold Trust (GLD NYSE), an exchange-traded fund to the 'Safety & Balance' portion of our model portfolio.

"Very simply put, gold prices reflect inflation and specifically interest rates. As rates rise, so does the price of gold. This is called a ‘positive correlation.’ I know that’s a two-word phrase I swore I’d never use in my efforts to keep things understandable, but hang in there just a little longer.

Next, recall that the higher interest rates go, the lower bond prices fall. This is called a 'negative or inverse' correlation. That’s where the yellow metal comes into play. Put the entire string together…when inflation rises, gold does too, but when gold goes up, bonds go down.

"Therefore, inflation causes gold to rise and bonds to fall. It’s not an exact science, but research suggests that there’s a 10-to-1 ratio, meaning that for every 10% change in bond prices, there’s a corresponding 100% change in gold prices in the opposite direction. So, our goal in owning gold at this juncture is to hedge the interest rate risk when inflationary pressures are rising. In this instance, it doesn’t matter if gold prices rise or fall. Now, I’m not saying that we won’t profit from gold; it’s just that in this instance we’re playing defense instead of offense.

"Until now, the only way to own real gold was to dig it out of the ground yourself or load up on coins, krugerrands, or gold dust. Thanks to GLD, that’s a thing of the past. "This ETF trades like a stock and has paltry expenses of 0.4% a year. Specifically, I want you to add up the assets from the above three bond positions, and buy the equivalent of 1% of the value in GLD. So, if you have $50,000 among the three, buy $500 of GLD at the market. If it’s $100,000, buy $1,000 of GLD, and so on. Each share represents 1/10th of an ounce of gold. Therefore, it’s as near a path to direct ownership as possible.

"In stark contrast to bullion or futures contracts, you don’t have to worry about taking delivery or storing it somewhere either. And with GLD, we don’t need to be concerned with the mining side of the equation. Historically speaking, mining shares aren’t the bed of roses everybody thinks they are either. You can never tell exactly what companies involved are doing or going to do, and that makes them too risky for my taste. GLD makes buying gold as easy as buying a stock—without exposing you to the inflationary and environmental risks mining shares are famous for—and any holding that lessens our exposure to inflation is a good thing."

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