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A reader writes in to ask:

“A relative has been saying that our economy is going to collapse and I should put money in gold because the world will fall back on it. What do you think about precious metals?”

There has been tremendous investor interest in gold and other precious metals in recent years. Gold has a 5-year average annual return of over 21%, which would be a stellar return in any investing climate, and looks positively otherworldly in today’s. It’s gotten so that you can’t pick up a newspaper or drive down a highway without seeing ads for buying or selling gold.

Is the world economy going to collapse and return to bartering in gold? I’ve examined a lot of the conservative/survivalist arguments and continue to feel that’s unlikely, though never impossible. In reality, I suspect that if world affairs get so bad that we are using gold to buy bread, that we’ll have other, larger problems on our hands. We’d probably be involved in a catastrophe on a scale that would be impossible to prepare for anyway.

So let’s look at gold and other precious metals as a pure investment or hedge, for diversifying our portfolios. Many advisors label gold as a poor investment, or not an “investment” at all, because it produces no income. But that’s a narrow view in my opinion. The fact is that gold has historically been one of the asset classes least correlated to stock prices. When stocks have gone down, gold has gone up, and vice-versa. (For the technically minded, gold’s correlation with the S&P 500 over the last 10 years has been -0.01, where 1 is perfectly correlated and 0 is uncorrelated.)

So gold is an excellent asset to hold if you want to compensate for the stock market’s volatility. For example, you might want an investment you could sell at a profit, when the market is down for a period, to live on in retirement perhaps.

I also feel it is wise to hold some assets that are isolated in some sense from the global financial system that is so subject to political and economic winds at a high level, as well as friction, expenses, and outright fraud at lower levels. I would suggest that everybody hold at least a small portion of their assets in a contrarian or local position, something where they feel a personal connection and can have some personal control. Gold can fill that need, but there are other good options: commodities, collectibles, local rental property, a small business, for example….

How much of your assets should you hold in this “hedge” position? Traditional advice ranges from around 5% up to as much as 25%. You’ll have to make your own judgment, though I would suggest starting small until you understand all the relevant issues. Another reason to start small, at least if you choose gold, is that stellar 21% return quoted at the start. Gold has been surging for much of the last decade. It’s anybody’s guess how long that could continue, but statistics tell us that most investments are cyclical, and that hot streaks always come to an end.