Gold - The Beginning of the Plunge?

Last Updated Jan 25, 2011 8:43 PM EST

"Traders dump gold" was the headline of the day, according to an article from "The Street." Gold is down nearly $100 from its high on December 7 of last year. Is this seven percent decline merely a breather, or is it the harbinger of a larger decline?
Behind the decline
Typically, gold does well when the dollar declines. Yet markets often make fools out of investors who rely on typical patterns. As weak as the dollar has been so far this year, gold has been weaker.

I could go on and on about why the experts think the price of gold has declined, but a much better explanation can be found in the financial equivalent of the law of gravity. What goes up must come down or, in this case, nothing can continue to go up at a high rate forever. That's true even for gold.

Cramer on gold
According to Jim Cramer, here's what you should do with gold:
"Trade gold as a short ... for an investment it's a long ... They can be two different things." Cramer went on to say that if he was at his hedge fund, he would be buying gold puts against his existing gold position, and then reversing that trade at the end of the month.
Personally, I tend to take any advice from Cramer with a grain of salt, make that a block of salt. So I consider his advice on gold to be about as good as his prior advice about Bear Stearns not being in trouble. Yet it is a clear sign that certain investors are hedging their bets on gold's rise to $3,500.

Lessons from my past
This pull back of gold reminds me of the time back in 1980 when I bought gold for $664 an ounce after a pull back. Fresh out of college, and with great expectations, I bought the shiny metal. Instead of making a fortune, my investment didn't even keep up with inflation, a mistake I can now recognize in hindsight.

Assuming that gold will follow the same pattern as in the 1980's, would also be a mistake. And an even bigger mistake, would be to assume that paper currencies will go the way of the buffalo and we'll return to the gold standard.

My prediction
Bubbles are hard to spot, but I do think these are signs of a gold bubble:
  • People are sure of its constant future gains.
  • People are telling me I "don't understand" the new paradigm.
  • Solicitors are constantly calling me to request that I buy gold from them.
The one thing in gold's favor is that it is nowhere near an all-time high in real, inflation-adjusted, terms.

My Advice
I happen to believe in gold and precious metals as a diversifier that often moves counter to stock markets. Unfortunately, most people buy it for the reason I did in 1980 - to get rich.

I happen to believe that the best way to invest in precious metals is through precious metals and mining stocks, which have far outpaced gold over the last three decades.

Two low cost diversified funds I like are the Van Eck Gold Miners ETF (GDX) and the Vanguard Precious Metals and Mining Fund (VGPMX). If you buy them, consider:
  • That they are near their highs, with only a modest pullback.
  • That they are extremely volatile and will make your stomach churn.
Buy them for the right reason - long-term diversification. Consider dollar-cost averaging your purchases. Keep your exposure to precious metals at no more than two percent of your portfolio.

When, or if, you buy, always keep in mind who is selling. I've recently sold some as part of my rebalancing strategy.

More on MoneyWatch
Why Gold Will Hit $3,500
Gold - My Best Investment Ever
Mathematics of Rebalancing
  • Allan Roth On Twitter»

    Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.

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