09/05/2013 08:30 am ET Updated Nov 05, 2013

Should Investors Own Gold?

I prefer to own productive well-managed assets that produce things people want and need and buy regularly. I want management of businesses to be honest and free from greed. I'd like the global financial system to be free from fraud and manipulation. I'd like to live in a country where present and future debt is a small percentage of GDP, and I'd like a balanced budget. I'd like the consequences of breaking laws to apply to those connected to Congress and the White House. I don't want the Federal Reserve Bank to buy the banking system's suspect assets or accept them as collateral for loans. I don't want the Fed to buy a boatload of treasury bonds. (I also wish I could be invisible at will and fly like superman.)

Since I live in the real world, not a world of my preferences and wishes, I diversify, and I own some gold. Gold is just one of many assets one can buy to diversify. Diversification doesn't mean you won't lose money. It just means it's unlikely you'll lose it all at once, and instead, you may do very well over time.

Some Gold Pros

Gold will rise and fall in price, and it doesn't generate any products or services. But it doesn't pose credit risk, and unlike many U.S. stocks, it has never traded at zero. It's a tangible asset at a time when there is reasonable distrust of many financial assets. There is also reasonable distrust in the managers of major banks and distrust of the representations of Central bankers and the IMF.

General Wesley Clark revealed a post-911 plan for taking out seven countries in five years: Iraq, Syria, Lebanon, Libya, Somalia, Sudan and Iran. The U.S. may soon be at war with Syria. Wars tend to drive up the prices of oil and gold.

Gold has an advantage over other currencies, because it can't be printed, and although it doesn't pay interest, interest rates are relatively low at present. Rates can change fast, but for now, interest rates are below real rates of inflation.

Some Gold Cons

Gold prices are unstable. Under normal conditions, changes in mining output, demand, unpredictable behavior by governments that own gold, and unstable emotional expectations about future prices whip around the price of gold, especially in the short run.

The price is very volatile, and at any given time, you do not know who is buying or selling gold or why. It could be manipulation; it could be a fund tired of a long or short position; a Central Bank might buy or sell, someone could be covering a margin call, or a fund might massively deleverage...anything. When gold took a fast nosedive earlier this year, it displayed to me the pattern of a large investment being deleveraged, but conspiracy theories abounded.

Diversify: If You Can't Predict the Future, Why Behave As If You Can?

Anyone who tells you they know where the price of gold will be next year or next month is fooling you. No one knows. No one can tell you today whether diversification into gold is a good idea, a neutral idea, or a bad idea. But almost everyone will tell you that diversification is generally a good idea.

How much gold should be in an investment portfolio?

The right answer for you might be zero.

Greg Mankiw, professor and chairman of the economics department of Harvard University, wrote a recent New York Times article, wherein he states he no longer has an aversion to gold and thinks a 2 percent weight in the world market portfolio makes sense. Later he wrote that the "correct" answer based on "roughly plausible" assumptions is 4 percent. But he made up his assumptions and didn't provide a timeframe for their basis. In other words, he doesn't know.

I met with a foreign fund manager with more than 50 percent of his assets invested in gold. He didn't know the "right" answer either.

Prudent investors don't invest in one or two assets, because the day will come when you will be wrong. I will write more about diversification in future. Meanwhile, here's a rule of thumb. If you invest in 15 assets, roughly a 6.7 percent weight for each, that will improve returns to risk by a factor of five. That's five times the return for the same amount of risk, and they don' have to be great assets, just good ones.

Good is relative. If you can't take price volatility in your investment portfolio, than gold isn't good for you. But good isn't always what it appears to be. "AAA" and "investment-grade" assets that were supposed to be "good" were junk when they were created. There's been no meaningful financial reform since the September 2008 financial crisis, and no meaningful felony indictments. Those are among the reasons why many of us who can take the price volatility own some gold.

This commentary is excerpted and adapted from a longer article that originally appeared at The Financial Report under the title: "Who Says Gold is Money? (Part Two)"