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Gold prices in freefall: Is now the time to buy?

The price of gold has fallen hard and fast, to about $1,600 an ounce from more than $1,900 just four months ago. Although there are plenty of reasons other than the recent sell-off to be sour on gold (it offers no yield nor earnings, for example), it turns out that adding some gold stocks to your equity portfolio could generate superior returns with less risk, new research shows.

Gold stocks have historically ranked among some of the most volatile asset classes, with any given one-year period serving up price changes of more than 35 percent in either direction, writes Frank Holmes, CEO and chief investment officer of U.S. Global Investors, in a new note to clients.

The source of that turmoil is the underlying price of gold bullion, which carries an annual volatility of about 13 percent. But despite that volatility, Holmes says investors can actually use gold stocks to enhance their returns without adding risk to their portfolios.

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Yes, it sounds too good to be true, but based on research first conducted by Wharton School finance professor Jeffrey Jaffe in 1989, U.S. Global Investors found that a small allocation to gold stocks boosts risk-adjusted returns by a significant margin.

"Between September 1971 and November 2011, the S&P 500 averaged a 9.69 percent annual return," Holmes writes. "A 15 percent allocation to gold equities and an 85 percent allocation to U.S. stocks, with annual rebalancing to maintain the allocations, would have yielded, on average, an additional 0.82 percent per year."

That extra 0.82 percent a year would have quietly compounded itself into much better returns over the long haul. For example, a hypothetical investment of $100 in the S&P 500 in 1971 would have grown to about $4,800 at the end of November 2011.

However, investors who allocated 15 percent (or $15) of that initial $100 investment to gold stocks back in 1971 would have seen their principal grow to about $6,600 by the end of November, U.S. Global Investors figures.

"That is 37 percent greater than the $4,800 for the portfolio solely invested in the S&P 500, while adding virtually zero risk," says Holmes. (Remember -- that's with annual rebalancing to maintain the allocations.)

If a 15 percent allocation to gold stocks is too much for your personal risk tolerance (or you have a healthy skepticism about investing in gold in the first place), a portfolio with a 10 percent weighting of gold stocks and a 90 percent allocation to the S&P 500 also historically boosted returns with no additional volatility, according to U.S. Global Investors.

"More than two decades and many ups and downs have passed since Jaffe published his study, but our follow-up research shows that the relationship among gold, outsized returns and volatility has remained consistent through the past four decades," Holmes says. "If you haven't already completed your annual portfolio rebalancing, [the recent sell-off] may be an opportune time recalibrate your portfolio with gold stocks."

Dan Burrows

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Dan Burrows, a veteran of Aol's DailyFinance, SmartMoney and MarketWatch from Dow Jones, covers the markets and economy with an eye toward investing for the long haul.

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