How to Protect Against Possible Gold Decline

NEW YORK (TheStreet) -- With bullion prices climbing, gold mining stocks have soared. During the past year, precious-metal funds have returned 52%, outpacing every other category tracked by Morningstar. Can the funds continue to shine? That's hard to know. Gold prices are notoriously difficult to forecast.

But there is a compelling case for owning a small stake in precious metals. For starters, gold can act as an insurance policy. While prices may bounce up and down, gold has always retained some value. In contrast, the price of a stock can drop to zero.

Gold can help to diversify a portfolio because it sometimes rises when stocks are falling, says Frank Holmes, a portfolio manager of U.S. Global Investors Gold and Precious Metals Fund(USERX Quote). Gold typically does best during periods when Washington is running a big budget deficit, Holmes says. Deficit spending can lead to inflation, a menace that causes investors to seek shelter in gold.

During the late 1990s, the U.S. ran a surplus, and gold funds lagged behind the S&P 500 Index. But, lately, gold has climbed as the deficit has exploded. During the past five years, precious-metal funds returned 18% annually, compared with 0.6% for the S&P 500.

To bet on gold, investors can hold either mining stocks or bullion. Mining stocks are more volatile, rising steeply when gold prices climb and dropping sharply when prices soften. To appreciate why the stocks can soar, consider that it currently costs some companies $500 to mine an ounce of gold that now sells for about $1,000. If the price of bullion climbs 10% to $1,100, mining profit margins would climb 20% as operating earnings rise from $500 to $600. When bullion prices fall, the process reverses. Margins narrow sharply, and the stocks can collapse.