Why you should invest in gold
Why Should You Invest in Gold
Traditional financial advice available for retail investors is almost entirely centered on equities and debt. Most model portfolios have nothing to say about the weights on alternative asset classes such as gold. Gold, in particular, is a glaring omission because unlike other alternatives it is quite cheap and easy for retail investors to buy gold – whether in physical format or through ETFs, mutual funds or sovereign gold bonds. In this article, we seek to plug that gap. According to us, gold can play a vital insurance/ diversification role in retail portfolios
Recommending gold is fraught with trouble. Many gold-junkies are people who invest in the yellow metal in preparation for some sort of “end-of-the-world” event. As a result, “serious” financial investors often scoff at gold. In India, gold has huge (often irrational) cultural significance. As a result “serious” financial investors (and advisors) in India scoff at gold even more. However modern finance, especially works in the area of currencies, can now be used to make some significant arguments in favor of gold. Like so many Indian things, it may just be a case of modern science making us realize that the ancients had it right after all!
Deconstructing the gold price in Indian rupees
- 1. What is happening to the gold price in dollars: This portion is affected by various international developments (such as global real interest in real rates) and the effect of India-specific factors is actually quite minimal. When global crises occur such as in 2008, then the international gold price moves up due to safe-haven demand while Indian equities are tanking. However, barring such events, it is difficult to see any clear value that gold price in dollars brings to an Indian equity-bond portfolio.
- 2. What is happening to the price of the Indian rupee in dollars: This is the interesting part. When people own gold, they are also implicitly holding a position in USDINR. This position will do well every time the rupee weakens and do badly when rupee strengthens – so a very clear India-specific angle.
(In practice the relationship between these 3 may not be exact because there is friction due to govt restrictions on gold imports etc which gives rise to the “Mumbai premium”. But that part is small and can be ignored for this discussion.)
USDINR component of gold gives it interesting hedging properties
Gold in INR is useful for protecting against the downside in Indian equities because of this USD INR component. Basically gold in INR does well when equities go down not because gold (as measured in USD) is necessarily doing well but because INR is doing poorly and getting weaker. And the fact is that when some big developments are taking place in India, then the volatility in USDINR can overcome the volatility of the gold in USD, so you see the USDINR effect coming through even more strongly.
Gold in INR can give returns when both equities and bonds are falling
Many people think of debt as adding stability to their portfolio. This is true when equities are doing poorly due to a slowdown in growth. During such times central banks cut rates to boost growth and hence bonds do well. However, both equities and bonds are vulnerable to periods of high inflation. Bonds do badly because the central bank is expected to increase rates to fight inflation. Counter-intuitively, equities also do badly, during inflationary episodes even if they may generate inflation-beating returns in the long-run. The case for why equities suffer during inflation in the short-run has been wonderfully articulated by Warren Buffet himself in his 1977 classic article “How inflation swindles the equity investor” and I will leave you to read that. Gold can come to the rescue during such inflationary episodes. High inflation is associated with an eventual depreciation in the Indian rupee which then reflects in the increased gold price.
Some encouraging statistics on Gold…
Given the discussion on gold so far, it should not come as a surprise that the monthly correlation of gold in INR with the Nifty and the 10-yr Government bond is -11% and -12% i.e. there is a lot of scope for diversification by adding gold to the portfolio.
…But with a few caveats
The biggest question in financial analysis is to what extent past performance can be projected forward. In this respect, two important observations can be made with respect to gold:
- We can more or less expect the diversification angle to continue going forward since there is a strong fundamental rationale for it.
- Whether gold returns will be as strong going forward is less clear. As we discussed earlier gold returns in INR, can be decomposed into gold returns in USD and USD INR returns. Even if we assume that the periodic bouts of high inflation will continue in India and hence the USDINR depreciation can be projected going forward, it is difficult to say that gold in USD will repeat its past performance. In the past 15 years, international developments have been in favor of gold. For the 20 years before that (1980-2000) gold in USD was in a big bear market. Going forward, the trend in gold will be determined by international developments which may have little or no relation to what is happening in India. Hence we cannot expect gold to repeat its stellar performance even if inflation remains a problem in India.
Finally, apart from this, gold unlike debt is a high volatility asset and does not provide regular coupon income.
So what role should Gold play in your portfolio?
Given the diversification that gold can provide, it definitely deserves a place in your portfolio. If the role of debt in a portfolio is to provide regular income and equities is to provide returns, then gold can provide insurance and diversification especially during high inflation periods. This helps to stabilize the year on year variation in equity returns.
- If you are investing for the very short-term (say emergency funds etc.) or need regular income then the role of gold should be minimal in your portfolio. This is because it does not provide regular income and returns can show significant variation over short-periods just like equities
- If you are investing for the very long-term then also gold may have a somewhat limited role relative to equities. This is because if you are a long-term investor and willing to live with substantial volatility in the meantime, then long horizons give sufficient time for equities to recover and provide high returns, reducing the need for diversification.
- The true value-add for gold comes in the medium term portfolios, say for a 3-8 year horizon and/or if you would like to avoid significant volatility in portfolio returns. In such portfolios, gold can provide returns when equities and bonds are not doing well, increasing your probability of ending up with good positive returns.
Data source: We have used the following sources for calculation returns – Equities: Nifty total return index; Gold: MCX Gold; 10-yr Gilts: Computed from generic yields and Risk-free rate: RBI repo rate.