The following is not just a trivia question: Picture the total volume of all the gold ever mined -- how many Olympic-size swimming pools would it fill?

The answer, which is at the end of this paragraph, sums up the powerful investment case for gold in this Neverland financial environment. The total supply of gold worldwide is small; if central banks, institutional investors, and individuals reallocate even a small percentage of their assets toward this precious metal to hedge against inflation, we could witness a significant rise in its price.

(Answer: Approximately three-and-a-half swimming pools.)

Gold -- a small piece of global assets
Here's another, more relevant, way to think about gold's scarcity. At the end of 2008, the total value of all mined gold was $4.56 trillion. While that number may appear large on its face, it represents just 2.6% of the stock of financial assets worldwide ($178 trillion).

Investors have held gold as a store of value since antiquity. At a time when the governments of industrialized nations (including, most prominently, the U.S.) are doing everything in their power to debase the value of their currencies, it would hardly be surprising to witness some shift into gold.

Looking back
Perhaps you think I'm jumping on the bandwagon at a time when gold is achieving new highs, but back in February, with gold trading below $1,000 per ounce, I wrote that "gold is an attractive choice for a portion of one's investable assets ... conditions look very favorable for gold to outperform the U.S. stock market in 2009 and over the next three to five years." But don't take my word for it; listen to John Paulson instead.

A master investor on gold
Paulson is the hedge fund manager who made a huge bet against subprime mortgages in the run-up to the crisis, producing a 590% return for his Credit Fund I in 2007 and netting himself $3.7 billion. This year, noting the Fed's massive expansion in the supply of dollars outstanding, Paulson is betting on gold: "What's the only asset that will hold value? It's got to be gold," he argues.

At the end of the third quarter, Paulson & Co. owned $3.1 billion worth of the SPDR Gold Trust exchange-traded fund -- more than 15% of the value of his share portfolio. Not to mention the fact that the company is also a large shareholder in several gold miners, including Kinross Gold (NYSE: KGC) and Gold Fields (NYSE: GFI).

"Three or four years from now, people will ask why they didn't buy gold earlier," Paulson concludes.

The trouble with gold
Still, investing in gold is not without its challenges. These are the two major problems I have with this asset:

  • There is no cash yield on gold. It doesn't pay a coupon or dividend, nor does it even provide its owner with an economic interest in a stream of profits. The only return one can expect is a capital gain at the time of resale.
  • That, in turn, means that gold can't be properly valued. For a value-focused investor, that's a fundamental shortcoming: I can construct a thesis according to which the price of gold will increase from its current level, but I don't know how to assign the "fair value" to the precious metal, which turns the selling decision into a bit of a guessing game, rather than a discipline.

An inflation hedge without the drawbacks
Which brings me to another asset class, which, like gold, offers an effective hedge against inflation, but has neither of gold's two disadvantages: dividend stocks.

  • Dividends provide investors with a direct return of income, which can be spent or reinvested. In the latter case, reinvesting dividends boosts the compounding function of wealth creation -- the key to staying ahead of inflation.
  • All stocks, whether they pay a dividend or not, can be valued on the basis of the cash flows the underlying businesses generate on behalf of their shareholders. However, high-quality dividend stocks tend to be relatively easier to value because they often belong to stable industries. That's useful: Being able to determine fair value with greater certainty reduces the risk of taking a capital loss on a stock.

The following table contains five dividend stocks of companies that are well-financed:

Company

Dividend Yield

Total Debt/Equity

Merck (NYSE: MRK)

4%

40%

Chevron (NYSE: CVX)

3.5%

12%

Intel (Nasdaq: INTC)

3.2%

6%

Automatic Data Processing (Nasdaq: ADP)

3.2%

1%

Marathon Oil (NYSE: MRO)

3.1%

39%

Source: Capital IQ, a division of Standard & Poor's. Data as of Jan. 29.

I continue to think that gold is an attractive option for part of one's investable assets. If I had to choose between the two, however, I'd be rather more comfortable owning a portfolio of high-quality dividend stocks, purchased at reasonable valuations (for the reasons I have indicated above). These are the stocks the team of analysts at Motley Fool Income Investor is constantly seeking out for its members.

If you're concerned that the Fed is creating a new set of risks and fear that inflation could take a savage toll on your wealth in the next few years, you should consider owning one or more of Income Investor's "Buy First" stocks. These seven stocks are the foundation on which investors can start to build a solid dividend portfolio and grow the purchasing power of their assets. To get started with those seven names, sign up for a 30-day free trial now.

This article was first published on Nov. 19, 2009. It has been updated.

Fool contributor Alex Dumortier has no beneficial interest in any of the companies mentioned in this article. Intel is a Motley Fool Inside Value pick. Automatic Data Processing is an Income Investor pick. Motley Fool Options has recommended a buy calls position on Intel. The Fool has a disclosure policy.