How to Use Gold ETFs

While inflation has not run out of control, the Federal Reserve’s aggressive quantitative easing plans are pushing wary investors to gold assets and exchange traded funds as a hedge against inflationary pressures.

Federal Reserve Chairman Ben Bernanke points out that investors hold gold as a protection against tail risk, low probability events, or “black swan” events, that could act as a catalyst to massive sell-offs in equities or hyperinflation, writes Michael Rawson, ETF analyst at Morningstar. [Gold ETFs Gain Inflows Despite Price Weakness]

“An asset that rises in value when most other assets decline should be very valuable,” Rawson said. “It can be thought of as a kind of insurance. To insure against bad times (that is, the aforementioned tail risks), people are willing to accept small losses in good times.”

Looking at gold prices dating back to 1973 from the London Bullion Market Assocation, the price of gold has shown a positive correlation to rising inflation and falling stocks. [Gold ETFs Hold $1,700 as Fiscal Cliff Talks Drag on]

Specifically, while stocks fell 15% in 1973 and then 26% in 1974 and inflation rose 3% in 1972 to 9% in 1973 and up to 12% in 1974, gold jumped 73% in 1973 and 66% in 1974. More recently, gold rose 4% in 2008 as the S&P 500 plunged 37%.

Over the past decade through 2011, gold appreciated 450% in value, compared to the 30% return in the S&P 500.

“Because the price of gold is sensitive to changes in inflation or the prospects of a disaster, a little bit goes a long way,” Rawson added. “For those who have decided to own some gold in their portfolios, we feel that 5% is an appropriate weight.”