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Investing in Gold as an Asset Class
Gold has always been special for people throughout history. It is revered as a luxury good, held with cultural significance across communities, considered a safe wealth preserver for inter-generational transfer and now increasingly, is being viewed as a form of strategic investment to diversify one’s portfolio.
Historical relationship between Gold and Currencies
Gold is a precious and scarce metal that has been used over time as a determining factor for currencies and as a guarantee to a secure currency. Till 1971, major currencies of the world, including the US Dollar, were pegged to value of Gold under the Gold Standard System. In 1971, US terminated convertibility of the dollar to gold, bringing the Bretton Woods system to an end and rendering the dollar a fiat currency, without any precious metal backing. Since then, Gold prices are set in the financial markets like any other precious metal. The financial market price is set between the London Bullion Market Association’s trading and the COMEX contracts in Chicago.
Gold as a diversifier
From a risk perspective, gold has provided some cushion to investors in times of significant market volatility or prolonged bearish trends. As an example, during the financial crisis of 2008, the Indian benchmark index NIFTY50 declined ~60% but Gold showed a 6% increase. Many investors have opted for gold as a valuable portfolio addition and it has acted as a diversifier – due to its low correlation to most mainstream assets – and as a hedge against systemic risk and strong stock market pullbacks.
Is Gold a good investment?
Making an investment in Gold with an implicit understanding that it will never lose value is not quite the correct assumption. Like any other financial asset class, historically, Gold has also had its period of ups and downs. As mentioned, it can be used as an effective hedging tool in times of very volatile or bearish markets, but should not be relied on completely for long term wealth creation. Unlike other investment options, it does not earn you any passive income if held in physical form. Stocks give return in the form of dividends and bonds yield periodic interest. Gold will give a return only in the form of capital appreciation (assuming there is one!) when an investor decides to sell.
In turbulent times like tensions between two nations (especially the middle east!), natural disasters, terrorism attacks, economic recessions, etc., investors heavily lean towards Gold. This often leads to an over-price situation, and Gold loses its sheen as soon as events normalize. In addition, possession of physical Gold requires storage and safety costs and has to be declared to the appropriate authorities for tax purpose.
Many investors instinctively think of Gold as a permanent wealth, an asset which has survived all historical troubles. This might hold true for the last century, but not anymore in the modern financial system.
The below charts will tell the story of investing in gold compared to equity in the last 25 years (as of 2018).
You are looking at the annual average price of 10 grams of gold in India over the past 25 years. The annualized return of gold over the past 25 years is around 8.1%. Now if we compare the same with investing in the NIFTY50 index (and not even active stock picking!), The annualized return of NIFTY 50 over the past 23 years (since 1995) is around 11.2%. As mentioned, there will be short term cycles of downturn, but the overall trend is significantly positive.
To provide another compact 5-year and 10-year view of return comparisons of different asset classes over a longer time frame, we did a 1980-2016 comparison between Gold, SENSEX, and Fixed deposits. We computed the average 5 year and 10 year returns an investor would have made on these asset classes.
From the chart it is clear that Equity investments will generally out-pace the returns from Gold, land and fixed income instruments, especially for emerging economies like India in the longer time frame.
Which form of Gold to invest in?
The most common investment in Gold is done by holding it physically in the form of jewelry, coins or bars. Investors need to note that in case of jewelry, an additional 7% - 25% making charges are needed to be paid, depending on the retailer. Gold coins and bars can be bought from retailers, banks and fintech platforms on which taxes are needed to be paid and purity to be verified. This form of Gold investment which sits in a locker, also requires additional spending to ensure its safety
The global financial crisis of 2008 led to the emergence of “financialization” of Gold in the form of ETFs, Derivatives, Mutual Funds and Bonds. This led to the mechanism of owning the precious metal in financial form instead of the physical form.
Gold exchange traded funds (ETFs) are basically a paper gold asset where the investors cannot claim physical gold in exchange. One unit of ETF is generally equal to 1gm gold and is held in electronic form. On redemption, the investor will get money equivalent to the price of gold.
Gold Mutual funds
In case of Gold mutual funds, the underlying asset is gold ETF which is pegged to gold price, and returns are equivalent to 24K Gold price. However, gold mutual funds have a higher expense ratio compared to a Gold ETF.
Sovereign gold bond, or SGBs, are government securities denominated in grams of gold. They are substitutes for holding physical gold. Investors have to pay the issue price in cash and the bonds will be redeemed in cash on maturity.
As a rule of thumb, it is recommended to have at least 10% of the portfolio as Gold. Investor can even have higher allocation but the choice is dependent on a lot of factors like risk profile, financial needs, generational wealth transfer, etc. Gold is a relatively less volatile asset and a good hedge in times of bearish market trends. However, it is still a passive strategy of investing, and should not be solely relied upon for long term wealth creation.
Please explore the ALPHABETA Guide platform that helps in examining the relationship between gold and other different asset classes over time.Comments