Should you invest in Gold

Tuesday, May 23, 2017 Swati Aggarwal 3 Comments

 


Gold can play a very valuable role in equity and bond portfolios, doing well when both equities and bonds are under-performing. Hence long-term investors should definitely consider investing 5-20% of their portfolios in gold even though the recent price action has not been very encouraging.

What does the gold price even mean?

This question may seem strange. Of course gold price is the amount of rupees I need to spend to buy a certain amount of gold. But while it may be natural for us in India to think of the gold price in Indian rupees, this rupee price of gold is actually a derived price with two different components:

What is happening to the gold price in dollars: This portion is affected by various international developments; the effect of India-specific factors is actually quite minimal.

What is happening to the price of 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 government 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 makes it useful in reducing equity downside

USDINR is strongly correlated with Indian equities. The relationship is negative, i.e. (usually) when Indian equities go up (down) then the rupee is also strengthening (weakening) at the same time. Very intuitively this is because all factors that are big negatives for Indian equities (growth crises in the world and/or India and high inflation in India) are all also big negatives for INR. 

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.

This explanation is also borne by data. The chart below shows the performance of USDINR and Gold in INR when equities have been down by more than 20%.

USDINR and Gold have been up in recent episodes when equities were down by >20%
 

Also in the long run, the correlation between the monthly returns of gold and Nifty in the 15 year period from 2002-2016 has been -7% highlighting that these are two positive return asset classes which behave differently from each other – pure gold (pun intended) from a portfolio construction perspective!

Gold can also give returns when bonds are falling

Many people think of debt as adding stability to their portfolio. While this is mostly true, bonds themselves (esp. those with long maturity) can do extremely badly during periods of high inflation because the central bank is expected to increase rates to fight inflation.

However, high inflation periods are also when INR depreciates or in other word gold in INR is likely to do well. This explanation is again supported by data. The correlation between the monthly returns of gold and a 10-year government bond index between 2002-17 has been -12%.

Who is gold not for?

So far we have shown that gold can be a valuable third asset component in equity-bond portfolios. However there are at least 2 portfolios/requirements for which gold may not be very useful.

First, is for investors who are investing money for regular income or other short-term objectives such as emergency funds. Gold does not generate regular interest or dividends. Further short-term investors are mostly invested in short-duration debt instruments which provide low but steady returns and do not need diversification.

Second, is for investors at the opposite end of the spectrum who want to invest for the long term and are not concerned about (even significant) volatility in the meantime. In such cases, investors have low need for diversification and would rather put all their money in the highest returning asset namely equities. However, in my experience, such investors are very rare in real life.

The Final word

Both data and intuitive explanation show that gold can be extremely useful in most portfolios due to its ability to give positive returns when both equities and bonds are giving negative returns. Our analysis shows that a 5-20% allocation to gold is desirable with the exact percentage depending on an investor’s goal and risk appetite.


This article was first published on IIFL website on May 18, 2017.

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