What’s so important about gold?

Once dismissed as primitive and irrelevant, gold has been rediscovered by investors. Little wonder, says John Stepek. Here, he explains why gold is an essential part of your portfolio.

Here at MoneyWeek magazine, we've liked gold for a long time.

Back in 2001 when we launched, that was a downright contrarian stance.

Gordon Brown had just flogged off most of Britain's gold reserves. Gold and real' assets in general were seen as relics of a bygone era: primitive, uncivilised even.

We didn't need gold any more. We had clever central bankers who knew how to keep the economy running smoothly. With them in charge, managing our interest rates and keeping an eye on our supplies of paper money, we didn't need the artificial restraint of a gold standard.

Gold was shunned: if it had no use as money any more, then what was the point of it? By 2001, the price had fallen to below $300 an ounce, having once back in 1980 scaled the heights of $800.

Yet now most people would bite your arm off to buy gold at $800 an ounce. Gold is no longer a contrarian bet. It features regularly in the money sections of newspapers. There are we buy your gold' shops everywhere. And more and more funds and financial services companies are setting up to cash in on the boom.

It's not a bubble either. It's still held in contempt by the economic elite'. Apart from the odd dissenting voice buried in the back pages, you'll rarely find a pro-gold story in the FT or The Economist, for example.

But gold's appeal has certainly been rediscovered by the wider investing public. And it's little wonder why. Because those ever-so-clever central bankers screwed up badly.

The best way to think of gold

I find that the best way to think of gold is as a currency.

Gold has been used as money throughout history. That's because it's well suited to being money.

It's durable - you don't have to worry about it rotting or rusting, so you can hold on to it if you don't want to spend it right away.

It's fungible - one bit of gold of a given quantity is just like another. And it's portable, within reason.

Indeed, gold had an official role in the monetary system right up until 1971, when Richard Nixon severed the link between gold and the US dollar.

So given its history, it makes perfect sense to think of it as currency.

What's special about gold is that it's a currency that no one can print. You have to dig it out of the ground. It also can't go bust. History is littered with paper currencies that are literally worthless. Gold's value has never fallen to zero.

So at a time when central banks are printing money like mad, with no clear idea of what impact it might have, it makes sense that demand for gold increases. Because, to put it simply, the amount of paper money in the world is going up a lot faster than the amount of real money' - gold.

That's the case for owning it, and I think it's a sensible one. But how much of it should you own?

Gold as insurance

I like gold. But after 11 years of constant increases, I believe we're nearer to the end of the gold bull market than to the start. This is the stage where more and more people are going to start piling in for the wrong reason. They'll buy gold because it's going up, not because it's a sensible investment.

That means that this is also the stage where even though there are likely higher peaks ahead of us some people are going to start getting badly burnt in the inevitable panic sell-offs.

So it's important to get your rationale for buying gold right. It's not 2001 any more. You can't just buy it and sit on it, safe in the knowledge that chances are, it will never ever be that cheap again, and that you'll always be able to sell at a profit.

And if you're hoping to ride the bubble' when it comes, put that thought out of your head right now. That way, financial disaster lies. Timing a bull or bear market is painful. No one can know when the final peak or trough will come.

So what do you do?

Well, another way to think of gold is as an insurance policy. You don't put your entire portfolio in gold. It's something that you hold to insure the rest of your portfolio against financial disaster.

The possibility of such a disaster seems quite high just now, which is why the insurance policy (gold) is more expensive than it once was.

So we'd suggest that you invest 5-10% of your portfolio in some form of physical gold (gold stocks are separate they're driven by more than just the gold price, and they're certainly not insurance).

And when you check your portfolio every six months or so, you rebalance accordingly if gold's share of your portfolio is creeping higher, sell some and invest in something else. If it's dipping, then top it up.

That way, you'll profit from the inevitable bubble' phase. But you won't be left over-exposed when prices go down, as they one day will.

And when the gold bull-runis over, you'll be pleased. Because when the gold price re-enters a bear market, it'll be because the wider economy is finally turning around. And you'll be able to buy cheap insurance again for the next crisis.

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