Gold is traditionally seen as a bastion of safety in uncertain times. When currency is in flux, when stocks are volatile and when the wealth of a nation appears to be gutted, that's when this precious metal attracts a lot of attention.

Given the economic turmoil and fears of inflation that give gold a boost, James DiGeorgia, editor of the Gold and Energy Report (www.goldandenergyadvisor.com), suggests that strong buying by the investing public and speculators could drive the price of gold to $2,500 to $5,000 per ounce. With the unstable stock market, meanwhile, DiGeorgia says more investors are now looking to gold for bigger returns as well. Independent investment demand for gold is up 121% since January 1.

Yet when you ask different analysts, the future of gold seems much more problematic than that-and there are big discrepancies in the latest investment outlooks for the metal.

Over the past year, gold bullion prices broke above $1,000 an ounce only to fall below $900. Gold prices rallied on fears about the banking system. But then they pulled back amid stock market rallies. Later, gold surged again as the dollar weakened and inflation fears spread.

As of mid-August, the price of gold had risen to $946 from a low of $866 earlier this year, during a period when the dollar declined to a six-month low against the euro and other currencies.

"It is no sure thing," DiGeorgia acknowledges about gold. "There are always exogenous factors. U.S. government bailouts have hit $12.8 trillion. And current government economic plans will increase our debt by a staggering $9.3 trillion over the next decade. If only 1% of current Wall Street investors cross over into gold, the gold market will expand to multiples of its current size."

Dan Deighan, CEO of Deighan Financial Advisors in Melbourne, Fla., is concerned about what would happen to gold holders if there were a big currency devaluation. In a worst-case scenario, people would use gold to pay for goods and services. Those who owned mining stocks, precious metals mutual funds or exchange-traded portfolios would have to sell their shares to get cash while the currency lost value. He favors legal tender gold coins to mining stocks and gold exchange-traded funds.

"It is important to have physical possession of the metal," he says. "The primary reason that we're investing client funds in gold bullion and coins is because it's a defensive play. Currency devaluation isn't extremely probable, but it's possible with a lot of things that are happening right now."

John Nadler, an analyst with Kitko Inc. in Montreal, says the gold price has eased because people are willing to take more risks in the stock market. As a result, demand for exchange-traded gold bullion funds faltered after hitting a record high in April.

Larry Adam, chief investment strategist with Deutsche Bank's private wealth management division in New York, says that inflation may not be a problem this year or in 2010. His forecast for this period calls for a 1.5% inflation rate in 2010 and a rise of just 7% in gold.

Another leading analyst believes that gold prices will remain strong, but not skyrocket. Philip Klapwijk, the chairman of GFMS Ltd., an independent London-based precious metals research company, says that the price of gold could exceed $1,100 per ounce because of safe harbor buying coupled with inflation fears.

"The price may have pulled back a fair bit from the February highs," he says. "But that was largely just the market's reaction to jewelry demand crumbling and scrap booming. It's far from 'game over' for investors and it will be that crowd which sets the price alight."

A GFMS report says U.S. fiscal and monetary policy as well as world central bank policies meant to keep interest rates low should generate higher inflation and gold prices. But Klapwijk cautions that gold prices could trade below $900 an ounce again until inflationary pressures build.

This variety of opinions is why buying and holding a fixed allocation to gold may not pay off in the long run with higher portfolio alpha values. In such a tempestuous environment, caution is key.

Rather than buying gold outright, it could be better for financial advisors to create a tuck-in tactical allocation for gold or for precious metals mutual funds in their clients' portfolios. Tactical allocation has been the suggestion of financial research over the past five years.

By making periodic incremental changes in asset mixes, you can lower client risk while still capturing the new opportunities triggered by gold's volatility.

When the correlation between gold, equity and bonds changes, the mix of assets in a portfolio can be readjusted, says Joe Brocato, a finance professor at Tarleton State University in Stephenville, Texas, in a 2005 study published in the Financial Review. Brocato analyzed a portfolio of gold and nine equity and debt assets. Over the business cycle, he found the variance and covariance among the assets changed considerably.

The reallocation of assets, the results indicated, proved more effective in improving a portfolio's risk-return profile than buying and holding a fixed percentage in each asset class. DiGeorgia recommends that advisors put about 15% of client assets in legal tender American Eagle gold coins, which could be stored in something like a safe deposit box.

But not all money managers believe that tactical allocation with gold is necessary. Michael Cuggino, manager of the Permanent Portfolio, keeps 20% in gold bullion, 5% in silver, 10% in Swiss francs, 30% in stocks and 15% in U.S. Treasury securities and corporate bonds. The fund, which sports a beta of just 0.78, is up 6% for 2009 through June and 8.8% over the past five years.
The gold position "works for us as part of overall long-term diversification strategy," he says. "Gold acts as a defensive asset that protects the portfolio from inflation and devaluation of paper assets."

How Safe?
Some research shows that investing in gold as a safe haven or inflation hedge can be treacherous. It works, but only for short periods, according to a 2009 study by finance professors Dirk G. Bower of Dublin City University and Brian Lucy at Trinity College in Dublin. The researchers compared the relationships between the price of gold and the prices of stocks and bonds over time in the United States, the United Kingdom and Germany.

For ten years before 2005, gold acted as a safe haven for stocks, but not bonds. In addition, it only functioned that way for a limited 15 trading days during periods of extreme shock.

In the long run, gold is not a safe haven, the study indicates. "Investors that hold gold more than 15 trading days after an extreme negative shock lose money with their gold investments."

Over the long run, however, the price of gold moves with the Consumer Price Index, according to a recent study by professors Eric Levin at the University of Glasgow and Robert Wright of the University of Strathclyde, both based in Glasgow, Scotland.

The bottom line: Investors should not expect soaring gold prices unless near-term inflation fears heat up. At best, over the long term financial advisors who hedge their clients' stock and bond positions in gold can expect that the negative correlation of gold with stocks and the low positive correlation with bonds will help a portfolio's risk-adjusted rate of return.

Only small stakes of 1% to 2% of assets in gold in low-risk portfolios and 2% to 4% gold in medium risk portfolios are needed to improve risk-adjusted performance, according to a 2006 study by the World Gold Council in New York and New Frontier Advisors in Boston. The study examined returns from 1974 through 2005.

The results showed the following:
Gold competes well with small-cap and emerging market equities as a diversifying asset.
Gold acted as a good inflation hedge by returning 2.1% when adjusted for inflation over the past 30 years ending in 2005.
Gold delivered twice the inflation-adjusted return on T-bills and sported a -15% correlation with T-bills. It had no correlation with bonds and a relationship of only 7 basis points with large-cap stocks.     

Although keeping a small stake in gold can act as a portfolio hedge, other financial research shows that it is not a sure thing in the long term. Diversification with gold lowered a portfolio's beta value but did not improve a portfolio's return per unit of risk, reported a 2005 working paper by Ryan Daly of the University of Albany published on the Social Science Research Network.

"Over the last ten and 30 years, adding gold to a portfolio did not generate alpha," Daly's study says. "Although risk and volatility are reduced, the returns are not enhanced and the value-added benefits of gold are not produced."

To improve gold's use as a portfolio hedge, some money managers suggest using the Dow/gold ratio as a beacon to make changes in the percentage allocated to gold or precious metals mining stocks (see chart). Dividing the Dow Jones Industrial Average by the price of gold shows how many ounces of gold it takes to buy a unit of the index.

Typically at the peak, when the Dow Jones/gold ratio is high-as it was in the mid-1960s and from 1999 to 2000-stocks are overvalued and overbought and carry record high price-to-earnings and price-to-book ratios. For example, in 1999, the average stock sported a price-to-earnings ratio of 33, and stocks were selling at more than five times book value, according to Golden Sextant Advisors in Boston. This period was also characterized by the excessive ownership of stocks and by excessive liquidity and credit-a scenario that typically leads to a decline in stock prices and an increase in gold prices.

By contrast, when the Dow/gold ratio is low and below 5, stocks are cheap and gold is overvalued. The low period occurred, for example, in the early 1980s to about 1995.

The average for the Dow/gold ratio was about 12.6 over the past 80 years. It hit an all-time high of 42 in 2000, but has dropped to about 13 as of this writing. During this period, gold has outperformed stocks by a wide margin.

On the downside, the ratio hit close to 1 in 1980. Afterward, gold prices performed poorly, while the stock market soared starting in midyear 1982. So where do we stand today as the ratio drops amid falling stock prices and rising gold prices?

Based on today's Dow/gold ratio, gold could be considered overvalued at $900 per ounce. But like many others, Mike Martin, the chief investment officer of Financial Advantage Inc. in Columbia, Md., says gold prices may rise because of the concerns about big government, deficits and future inflation. And since short-term Treasury securities pay almost no interest, the opportunity cost of holding gold is negligible.

At this writing, Martin had 9% of his client assets in a gold exchange-traded fund as a low-cost way to own bullion. "Clearly, there is a lot of room for the price of gold to rise and the value of the Dow components to fall, or both, based on the historic range of their relationship to each other," says Martin, the former director of research at T. Rowe Price. "The current price is way below the $2,000 inflation-adjusted level it reached the last time the world was dealing with very high dollar inflation in the late 1970s, early 1980s. So there is a lot of potential upside."

Martin, however, cautions that owning gold bullion traditionally has had disadvantages. Among those: It is a sterile asset in that it pays no interest or dividends; it can be expensive to store in a safe place, so there's a carrying cost; and the price has been highly volatile over the years.