When It Comes to Metals, Caution Is Golden Rule

Q: What economic conditions cause the price of gold to rise? Is this a particularly good time to be investing in gold? --G.W.

A: Typically, the price of gold closely tracks the actual rate of inflation--or the level of fear of perceived approaching inflation.

Why? In inflationary times, investors flee to the so-called hard assets--gold is perhaps the most popular of these--to protect themselves against the erosion of a currency’s buying power.

Just think about it: If the dollar is losing 10% of its value through inflation, it doesn’t make sense to hold “dollar denominated” assets, such as certificates of deposit, savings bonds and the like, because their value is eaten away by the inflation.

For example, if you invest $1,000 in a one-year CD paying 8% when the rate of inflation is 10%, you’re losing about 2%. Instead, the smart money moves to hard assets, such as the precious metals, whose value rises as the purchasing power of a currency declines.

Gold hit its peak value of $850 per ounce in 1980, just as the country was being ravaged by a long bout of double-digit inflation. But once inflation was controlled, the price of gold fell into the low $300 range. Although it has fluctuated over the years--it rose to $454 per ounce in mid-1987--gold has been out of favor among most investors for the better part of the last 13 years. Until recently.

Since the beginning of 1993, when gold was trading at about $330 per ounce, the price has risen to its current level of about $380. Investments in gold mutual funds--which own both gold-mining stocks and bullion--have skyrocketed. And so far this month, sales of the one-ounce American Eagle gold coin are running at about three times the pace of a year ago.

Why, you might ask? Inflation is considered well under control. Experts say they are mystified by the run-up of gold prices, but several suspect that fear of inflation is the root cause. So far this year, inflation is running at an annual rate of 4.3%. Although the rate is considerably above the 2.9% inflation factor of a year ago, it is hardly rampant, and vast stretches of the nation remain mired in the persistent recession.

Other possible theories include the election of President Clinton, whom some investors fear will be forced to resort to heavy government spending if he is to make good on his election promise to jump-start the nation’s economy.

Further, some investors are just plain worried because Clinton is the first Democrat in the White House since Jimmy Carter, who was widely blamed for the nation’s last round of horrific inflation.

Regardless of the cause, the price of gold is rising. What should you do about it?

First, you should take strong note of the fact that the recent rise in gold prices is still largely unexplained. Then you should remember the first adage of investing: Don’t play with scared money. Finally, small investors should look at the limited potential gains available through gold.

For example, if you buy gold when it is $380 per ounce and, let’s say, sell when it hits $450, your maximum potential profit is $70. (It will be less because of sales commissions, but we’ll get to that later.) Sure, that’s a profit margin of more than 18%, but you would have to buy nearly a pound of gold--at a total price of $6,080--to make a four-figure profit. Further, gold generates no dividends or interest while investors wait for their possible profits.

You should think of an ounce of gold as a single share of stock and ask yourself the following question: Would you buy shares for $380 apiece?

If you’re really interested in buying gold, first-time investors should follow these guidelines:

* “Paper trade” for at least a month before taking the plunge. You should track the price, calculate margins and make investment decisions on paper before putting up any cash.

* Take possession of whatever gold you purchase and keep it in your safety deposit box. Brokers will try to sell you on their storage programs, but too many investors have been defrauded this way. Store your gold carefully. Pure, 24-karat gold scratches easily, and the value of coins can be diminished by any blemishes.

* Untrained investors should limit their initial purchases to legal tender from known countries. Gold bullion, futures contracts and options are for the truly sophisticated gold trader. Among the most popular gold bullion coins are the American Eagle, the Australian Kangaroo Nugget and the Canadian Maple Leaf. Currencies from these and other major countries are guaranteed by the government, and the gold content of the coins is certified, allowing for easy resale.

* Understand the difference between the currency value of gold coins and their potential numismatic (collectible) value. Some coins are issued as currency at the going market price for gold, but later become prized as collectibles for their rarity. Only experienced and trained investors should consider the numismatic value of gold coins.

* Keep your sales commission charges as low as possible by buying in the largest quantity you can afford at a single time. Commission charges can range from 4% to 10%, depending on the size and timing of the purchase. Further, in California, any purchases under $1,000 are automatically subject to ordinary sales tax. Although gold is sold in quantities as small as 1/20 of an ounce, most brokers recommend against gold investments of less than one ounce.

* Finally, as with any investment, never commit more than you can afford to lose.