By John Waggoner
USA Today

Gold funds have soared an average 45 percent the past 12 months, leaving investors wondering: Is there a way to invest in gold funds without leaving your account strip-mined? The answer is a cautious yes - but only if you pair your gold fund with another type of fund.

As a group, gold funds are even more volatile than technology funds, regularly registering huge gains and losses in rapid succession. For example, the Lipper Gold Fund Index, which measures the performance of the largest gold funds, fell 17.1 percent in August 2002 and rose 16.1 percent the following month.

The funds are volatile because they invest in gold-mining stocks, rather than the yellow metal itself. And gold-mining stocks magnify gold's moves. That's because small moves in the price of gold have a huge effect on a mining stock's earnings.

Consider Newmont Mining, which produced about 7.3 million ounces of gold in 2003. Average cost to produce an ounce of gold: $198 to $208.

A change in gold prices goes straight to Newmont's bottom line. The company estimates that a $10 change in the price of gold - about a 2 percent rise from its current $410 - would translate into a $50 million change in earnings, all other things being equal.

Gold stocks fluctuate not only on the current gold price, but analysts' anticipation of the price six to 18 months in the future. Because gold is considered a safe harbor in catastrophic times, the threat of war can send gold stocks soaring. Outbreaks of brotherhood can send gold plummeting. In short, gold funds take the usual fluctuations of the gold market and put them on steroids.

Anyone who has watched gold funds over the years knows that the temptation to invest at just the wrong time is overwhelming - and the consequences can be lasting. Van Eck International Gold, for example, became one of the 50 largest stock funds in 1980, when the price of gold peaked at $850 an ounce. Those who bought in 1980 have earned an average 4.1 percent a year since, vs. 12.9 percent for the Standard & Poor's 500-stock index.

Given the history of gold stocks and gold funds, it makes sense to have an exit strategy before you invest. Predicting the price of gold isn't as difficult as predicting the Iowa caucuses, but it's close. The gold market is still haunted by the ghosts of analysts who predicted gold at $2,000 an ounce in 1980.

So if you're tempted by gold, hedge your bets. Consider pairing your gold fund with a fund that tends to move in the opposite direction. By doing so, you reduce the chance of getting severely burned. And at least in theory, mixing highly uncorrelated funds should increase your return.

Bond funds, and particularly government bond funds, have a negative correlation to gold. There's a reason: Traders push bond prices down when they suspect inflation is in the air. Inflation erodes the value of a bond's fixed interest payments. But gold is a classic inflation play. Investors often buy gold when paper currency loses value.

We looked at several portfolios consisting of the Lipper Gold Fund Index and the Lipper GNMA Fund Index, starting in 1985. GNMA funds invest in securities issued by Ginnie Mae, a government mortgage backer. A $10,000 investment in gold funds alone would be worth $25,600 now, vs. $42,900 in GNMA funds. Putting 20 percent in gold funds, however, would have boosted your return to $45,000. The portfolio was rebalanced regularly to keep the 80 percent GNMA/20 percent gold split.

Your results might vary. Gold funds are so volatile that one big year, or one big bad year, could skew your returns for several more to come. And rebalancing - moving money from a winning fund to a losing one - is a key element. If you can't stand shoveling money into a losing fund, the portfolio may not work.

Whether you mix in gold with GNMA funds, adding uncorrelated funds to a portfolio is nearly always a good idea. After all, large-company stock funds move in virtual lockstep with the S&P 500. Adding a large-company growth fund to one that tracks the S&P 500 won't help much. But adding a short-term government bond fund could, because the two types of funds often move in opposite directions.

So here's a tip. Mix gold - or other unrelated funds - into your portfolio, and you might increase your returns and reduce your risk.