Why you need a gold nest egg

If you're not diversified, your nest egg can be severely affected by a stockmarket crash. The good news is that gold is a safe haven - and you can put it in your pension fund too.

One of the most well known auditors in the world is David Walker. He is the top auditor of the U.S. government - the Comptroller and Auditor General and the head of the non-partisan Government Accountability Office (GAO). He cannot be pigeon-holed as a "doom and gloom merchant".

Last March he was interviewed on CBS' "60 Minutes'. He said that politicians in Washington were 'bankrupting America'. He's now on a 'Fiscal Wake-up Tour" across America taking his message directly to the people, as he feels that much of the media and politicians in Washington are ignoring the massive long term fiscal challenges facing the U.S.

This August he wrote a piece in the opinions/editorials section of the Financial Times where he outlined his concerns: 'America is a great nation, probably the greatest in history. But if we want to keep America great, we have to recognise reality and make needed changes... There are striking similarities between America's current situation and that of another great power from the past: Rome.

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'The Roman Empire lasted 1,000 years, but only about half that time as a republic. The Roman Republic fell for many reasons, but three reasons are worth remembering: declining moral values and political civility at home, an over-confident and over-extended military in foreign lands, and fiscal irresponsibility by the central government. Sound familiar?'

There are clear parallels between the huge challenges facing the US socially, politically and economically and those that led to the fall of the Roman Empire. With the emergence of rival superpowers such as China in the 21st Century, investors would be wise to be cognoscente of these big picture geopolitical trends and invest accordingly.

Successful investing is about the diversification and management of risk. In layman's terms this means not having all your eggs in one basket. We know from history that markets can and do occasionally crash and if you are not diversified, your nest egg can be severely affected.

This principle is an important one and should be observed by all investors. Most investors have most of their wealth in the stock and property markets. This strategy of having nearly all our eggs in these baskets has been successful in recent years. However, past performance is no guarantee of future returns and there are increasing signs that it would be wise to reduce allocations to these asset classes and look at other asset classes.

A healthy portfolio includes a wide range of assets including a properly diversified residential and commercial property portfolio; a variety of equities with exposures to different market sectors and regions; a small allocation to a variety of conservative government bonds; a rainy day' cash component and a 10-15% allocation to gold bullion.

Holding gold bullion in a portfolio can provide distinct benefits in the form of speculative gains, investment gains, hedging against macroeconomic and geopolitical risk and or wealth preservation. Importantly, gold is the only asset class with an inverse or negative correlation to the US dollar and to conventional assets such as bonds, stocks and property all of which are denominated in fiat paper currencies such as the US dollar, the Euro and the British pound.

Traditional asset allocation theory, as represented by the investment pyramid, advocates higher risk speculations at the top, with lower risk assets at the bottom. Futures contracts, options, individual shares and spread betting should be placed at the top of the pyramid, while cash equivalents and physical bullion, either fully allocated or delivered (as is done by the world's Central Banks) should form the foundation or base.

In dollar terms, gold returned 24.75% in 2006, rising from $497 to $620 per ounce. It thus completed its 5th year of gains and is up by more than 160% in the last 5 years. So far in 2007, gold has returned 22.5% in dollar terms, rising from $620 to $760 per ounce.

Most commodity analysts remain bullish on both gold and (particularly) silver and believe that they are now both in multi-year bull markets. Commodities, like all asset classes follow long term economic cycles. Commodities increased in value in the late 1960's and 1970's. They broadly declined in value in the 1980's and 1990's and have been rising again since 2001.

We are not as confident on the outlook on some commodities such as base metals and some soft commodities which are more cyclical in nature and would likely be affected by a slowdown in the U.S. and global economy. Gold on the other hand is not solely a commodity but more importantly a universal finite currency held by every Central Bank of note in the world.

It is the only currency academically proven to have an inverse correlation to conventional assets such as bonds, equities and property. We believe gold will surpass its non-inflation adjusted high of $850 per ounce by early 2008 and its inflation adjusted high of some $2,400 per ounce in the next 10 years.

Highly respected analyst, Louise Yamada sees gold surpassing $730 this year on its way to $3,000 within a decade. "Gold is the purest play against the dollar,'' said Louise Yamada, managing director of Yamada Technical Research Advisors and former head of technical research at Citigroup. Yamada was voted Wall Street's best technical analyst from 2001 to 2004.

Among the world's biggest financial institutions such as JPMorgan Chase & Co., Merrill Lynch and UBS, gold is also favoured by their analysts. Deutsche Bank AG's chief metals economist, Peter Richardson, made gold his favourite pick for 2007. "If you can only make one commodity investment,'' gold is the "choice for 2007."

Gold is becoming Wall Street's darling again due to what Bloomberg's Pham-Duy Nguyen said was "the swooning U.S. dollar, which has become a proxy for the slowing American economy and the nation's humiliating lack of success arranging regime change in Iraq, banning weapons of mass destruction in North Korea and Iran and reducing its trade and budget deficits.'

The fundamental reasons for owning gold and silver in the last five years have not changed, indeed most of them have become stronger:

Demand factors:

- A record and unprecedented US trade, budget & current account deficits. - Rising oil & energy prices with the consequent inflation and gradual realisation that Peak Oil' is a reality.

- Overvalued, plateauing and falling property markets.

- Rising interest rates in the US and globally.

- Record consumer, mortgage and national debt levels in the US and much of the western world.

- Increasing pensions stresses from underfunding and the 'demographic time bomb' of retiring Baby Boomers'.

- The growing realisation of the long term impacts that global warming will have on all societies and economies as outlined in the Stern Report.

- Geopolitical instability and the War on Terror'.

- A depreciating and declining US dollar - the global reserve currency.

Increasing global investor demand for safe haven assets. Also, Central Bank demand for gold to provide currency backing and stability to monetary reserves.

Supply Factors:

It is estimated that all of the above ground stocks of gold ever mined could fit into a 20 metre high cube. Gold is thus very rare and in limited supply.

Gold production is stagnating and gold output in the leading gold producing countries continues to stagnate despite higher gold prices. This is leading geologists to wonder whether we have reached the point of peak gold production.

- It takes 10-15 years to take a mine to production and many mines have closed down in recent years.

- High energy prices make mining an expensive proposition.

- Environmental legislation stymies mine development.

- Many mines are in unstable countries and regions such as South America, Africa, the Middle East and Russia.

- Central banks sales have slowed and in some cases reversed; the Argentinian, South African, Russian and Chinese central banks are some of the more significant buyers of gold in recent months.

Investing in gold bullion has its tax attractions too. The EU harmonised the treatment of gold for investment purposes in 2000 with the introduction of the EU Gold Directive. It means that investment grade gold bullion for investment is now tax free throughout the EU. There is no VAT and gold bullion is stamp duty exempt (unlike property and equities) throughout the EU. The only tax applicable is capital gains tax which is applicable on the majority of investments.

Investing gold in your pension fund

Importantly, residents of the UK, can invest in gold bullion in their pension funds. As of April 2006 they can invest in gold bullion through their Self-Invested Personal Pensions (Sipps). US citizens can already do so in their Individual Retirement Accounts (IRA's).

Gold bullion is allowed in a pension fund providing it is investment grade gold which is gold of a purity not less than 995 thousandths or 99.5% pure and that the bullion must be immoveable and stored with a secure and regulated third party. It cannot be taken in physical possession and used as a "pride in possession" asset.

The Perth Mint Certificate Programme, as the only government-owned and run gold certificate programme in the world, fulfills this criterion. It is the oldest operating mint in the world (established 1899) and has an AAA rating from Standard and Poor's and as such is a legitimate way UK investors can invest in gold bullion within their Sipp.

Risk conscious investors have long known that gold is a sound investment choice. Gold is stable in times of global geopolitical instability and when economic uncertainty, recessions and depressions prevail. Used correctly, gold and silver can be highly effective components of a properly diversified investment portfolio.

Gold remains an under-appreciated, under-owned and undervalued asset. Most investors remain ignorant about gold and sometimes fundamentally misunderstand it. At the beginning of the 1970s, when gold was about to undertake its historic move from $35 per ounce to $850 per ounce for a return of nearly 3000% in the subsequent 10 years, the same observations would have been valid. The only difference between then and now is that the fundamentals are actually even stronger today.

While the U.S. is unlikely to go the way of Rome anytime soon, the significant long term fiscal challenges facing the U.S. as outlined by the Comptroller General, David Walker, suggest some diversification into gold makes sense.

By Mark O'Byrne for The Daily Reckoning. Click here to sign up now.