We received many e-mails last week questioning our logic that gold is not a long term hold but rather a trading instrument inside a portfolio.

In one case, Ron Meisels wrote that “we and our clients at Phases & Cycles really appreciate your above quoted article (National Post - December 19, 2005), as we are always looking for buying opportunities in the Metal and Gold Sector, and your article may create some sellers.”

Well thank you for the input, although we hardly think we have enough influence in the market to sway the tide between gold buyers and sellers.

Mr. Meisels was opposed to our view that “gold can have a small role in a portfolio”, but “as a long-term, buy-and-hold growth asset, gold has historically had very little value”.

He also took exception to our position that gold will not “have much long term value going forward”, because his research suggests that portfolios “should have an over-weight position in these (and other Metal) securities.”

He went on to provide examples of gold mining companies that have had stellar returns over the past decade implying, we presume, that gold mining companies make excellent long term holds.

Allow us to respond. We suggested that gold – as in gold bullion - is not a particularly attractive long term investment within a portfolio. In our opinion, gold bullion does not have sufficient value as a hedge to justify the long periods where it earns zero return.

On the other hand, we did not suggest that a small position in commodity based companies (including gold companies) was inappropriate within a portfolio. But a gold stock, or any commodity based company, is very different from gold bullion or any other underlying commodity. Blue chip gold companies, for example, pay dividends and their value is based on the spread between their cost of production and the market price of gold.

Furthermore, the sustainability of a gold mining company is not based solely on the market price of gold. Gold companies can enhance their position by improving margins, or increasing productivity, neither of which depends on the price of gold rising. That, in the current environment gold is rising, simply adds value to the equation.

In short, a gold mining company is not holding gold as a hedge or as a long term investment, but rather is mining a commodity to sell at the best price it can get. When it comes to gold inside a portfolio, we think individual investors should think along the same lines; if you want gold bullion as a hedge in a portfolio, be prepared to trade it, if you want gold longer term, think about using gold companies.

That takes us to the second point; should gold or any commodity based company be part of a long term portfolio, and if so, to what extent?

When we talk long term growth assets, we are talking about assets that tend to move in tandem with the economy. The underlying belief system on which we define these assets is straightforward; a healthy economy has an ebb and flow that can sometimes cause serious shocks, but over long periods, a healthy economy will grow. Assets that mirror the economy should be able to leverage on that growth and ultimately, produce the desired long term results.

The best way to mirror economic growth is to hold a broadly based portfolio of equity securities. If we are to mirror the Canadian economy we must, by definition, hold some commodity based assets (i.e. gold and oil companies), because commodities represent a significant component of the Canadian economy. But we get that by holding broad based investments in broad based indexes like the S&P TSX 60, or broadly based actively managed Canadian equity mutual funds.

If we are to hold an overweight position in commodities, then we need to add to the embedded weightings that already exist within the Canadian index or the Canadian equity based mutual fund. Which, we grant, may have merit at points along the business cycle.

In recognition of that latter point, a well thought out portfolio should soften the natural ebb and flow of the economy. If we can accomplish that, investors can avoid shocks and by doing so, have a much better chance of staying invested long enough to enjoy the benefits of economic growth.

At points along the business cycle, commodities can buffer short term ebbs and flows. If, of course, you have the foresight to take overweight positions at appropriate points. Similarly, those of you blessed with foresight, would also recognize that there are times when commodities should be underweighted, in order to allow for the full benefits of economic growth to filter down to the portfolio. But, and here is our point, does this not imply one should be trading the asset class, rather than buying and holding the asset class.

In terms of the portfolio our conclusions are; gold bullion is, at best, a trading instrument. It provides very little in the way of long term value. Holding a market weight position in commodity based companies within a broadly based Canadian index - or equity fund – can deliver long term value within a portfolio. Having an overweight position in commodity based companies at points along the business cycle can smooth out short term portfolio fluctuations. Assuming of course, you are nimble enough to make these calls.

Finally, a decision to buy gold because you think it has great potential is an investment decision, not a portfolio decision.

We rest our case.