How Investors Should Approach Physical Gold

Despite the glitter, Buffett believes pretty is as pretty does

physical gold“Money will always flow toward opportunity,” Warren Buffett has said — and that as much as anything explains why the price of gold has jumped and slumped this year. Investors, who hedged against fallout from Europe’s default threats in 2010, engaged in profit-taking early this year. Since then, the market has swung wildly from rally to selloff — and back to rally.

Since Jan. 1, gold is up about 30%, but it has been a bumpy ride. Over the past 60 days alone, the yellow metal has swung from a high of nearly $1,900 to a low of about $1,600 and back up to $1,780 — with several peaks and valleys in between. While short-term gold speculators cashed in on the volatility play, 2011 has been more of a dizzying ride than an opportunity for income investors.

Despite the volatility — or perhaps because of it — having a little gold in some form makes sense for a well-diversified portfolio. But what form makes sense? Gold bugs have long touted the virtues of investing in physical gold over gold stocks or funds: intrinsic value, inflation protection and the confidence of being able to hold that tangible asset in your hand.

But those who prefer gold-focused equities or exchange-traded funds cite the problems with physical gold, which include storage, transport and security. Since you can’t slice a gold bar into small pieces, investors also need to ante up big when investing in physical gold. Gold exchange-traded funds also have tax advantages over holding physical gold.

Maybe that’s why Buffett is down on the idea of investing in physical gold, as he pointed out in his famous “gold fondling” interview with CNBC back in March.

The “Oracle of Omaha” differentiates between assets like stocks or farms, which produce something, and commodities like gold, which don’t.

“Gold is a way of going along on fear, and it’s been a pretty good way of going along on fear from time to time,” Buffett said. “But you really have to hope people become more afraid in the year or two years than they are now. And if they become more afraid you make money, if they become less afraid you lose money.”

Buffett illustrated the speculative nature of buying physical gold bullion or coins in this way: If you melted down all the gold in the world, you’d have a cube 67 feet high and worth (at March market prices) about $7 trillion. That amounts to about a third of the value of all the stocks in the U.S. Given the choice of owning a third of the stocks and that cube of gold, Buffett would choose the stocks in a heartbeat, because all the gold can do is “stand here and look pretty.”

No doubt about it, Buffett is putting his money where his mouth is. As InvestorPlace Editor Jeff Reeves pointed out this week, he’s just sunk $10.7 billion into IBM (NYSE:IBM) shares alone as part of a $24 billion stock spending spree.

But Buffett’s derision hasn’t tempered the physical gold bulls’ enthusiasm. At Monday’s City of Gold conference in Dubai, Standard Bank’s Walter de Wet predicted that physical gold would outsell gold ETFs by 500% this year.

With so many conflicting opinions, is now the time to add physical gold to your portfolio? For most investors, the answer probably is no. Unless you have nerves of steel and understand the nuances of short positions, gold-backed ETFs might be a better play for value investors now.

Consider funds like SPDR Gold Shares (NYSE:GLD) and iShares Gold Trust (NYSE:IAU), both of which are backed by physical gold on deposit. Because the funds trade over the exchange just like stocks, they’re easier to buy and sell. The up-front investment is far lower than with physical gold and they give investors liquid exposure to the sector.

Gold mining stocks like Barrick Gold (NYSE:ABX), Goldcorp (NYSE:GG) or Newmont Mining (NYSE:NEM) are another way to play gold, although they’re not the same thing as shares in a gold-backed fund. Market Vectors Gold Mining ETF (NYSE:GDX) is an easy way to gain exposure to multiple companies in the sector.

As of this writing, Susan J. Aluise did not hold a position in any of the aforementioned stocks.

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