Gold riskier than you think?

A speculative economy and cloudy outlook in the financial markets has sent investors flocking to gold in 2009. Before you take the plunge with what’s left of your savings and investments, take a closer look at what’s making this metal shine.

Recent email inquiry from a Stocknod member “With the recent upheaval in the economy and forecasts of a “second bubble”, I want to shift more of our investments in our 401k into precious metals (gold/silver). My financial advisor scoffs at this thought — like I’m a weirdo “gold/precious metal bug,” and I’m not. I just want to protect our 401K after the disastrous hit it took last year. What are some funds I could buy?”

First let me say that investment managers shouldn’t be scoffing at anyone these days. And you don’t have to be a “weirdo gold bug” to benefit from buying precious metals. My concern with Gold as posted by several of my blogs is that investors have been piling into gold for good reason, and there’s nothing wrong with the logic behind the case for buying. Gold has traditionally done very well in times of financial upheaval because of its perceived as a “safe investment” that can do no wrong.

The price of gold typically rises when the value of US Dollar falls. Similar to a lot of commodities. As the Federal Reserve and U.S. government have flooded the world with paper money to try to revive the global economy, gold bulls argue that it’s only a matter of time before inflation returns. Surging prices for goods also push gold prices higher.

All of these conditions have helped spark big demand for gold, which creates additional upward pressure on prices. But keep in mind that gold prices can fall sharply with little notice. So while it may provide a useful hedge, it’s not a great place to stash your entire nest egg. Especially with prices already through the roof.

Investors who did so in the late 1970s learned the hard way why gold can be so risky. As inflation raged, gold prices doubled in the ten months that ended in October 1979. Governments appeared powerless to stop the corrosive price spiral. Interest rates remained high because anyone lending paper money worried about its rapid loss of value. By January, 1980, gold prices had doubled again to hit $850 an ounce.

The Fed’s unprecedented moves to keep short-term interest rates at zero by flooding the system with cash is certainly cause for concern.

There’s little evidence of inflation in the economy today; the large excess capacity in housing, manufacturing capacity and labor markets are creating a big damper on prices. But if central bankers wait too long to mop up all that money, it could spark a fresh outbreak of inflation.

If you’re worried about inflation, there may be better ways to hedge. The price of metals like copper will likely rise if the global economy picks up and demand increases, especially in the developing world. (The same is true for oil.) For individual investors, there are a number of funds or ETFs that offer you a diversified basket of commodities.  Take a look at Pro Shares Ultra Gold EFF.