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Why Gold Is An Essential Evil In Your Portfolio?

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Importance of Gold in Portfolio

All that’s glittering right now is gold!

By: Tavaga Research

The millennials are aware of the fact that one should not easily get attracted to gold as it worsens the trade deficit numbers of an importing country, but there are proven justifications that make gold an essential asset class in one’s portfolio.

Before getting into the specifics concerning gold, here’s a small European story on potatoes. I am well aware of the fact that there are research analysts all over the world comparing returns of various asset classes (e.g. gold v/s Nifty 50 benchmark, gold v/s real estate) and here in this blog I am writing about potatoes from Europe! But let’s hear this short story which makes it easier for investors to realize the importance of gold.

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When potatoes first entered Europe in the 16th century, some elements opposed its usage of cooking and eating. Of course, there wasn’t any proven theory behind the opposition! Later on, the opponents and the farmers realized the importance of potatoes during the turbulent times of war. While looting grains and animals, the soldiers and armies fighting in the war, crushed the crops and destroyed the agricultural produce of farmers. What they couldn’t achieve was destroying and looting potatoes which were deep inside the agricultural land. Hence, the farmers who seeded the potatoes weren’t left to starve because of the war. In the same way, retail investors have realized the significance of holding the rare metal in the portfolio during such turbulent times.

What Has One Missed Because Of The Absence of Gold In The Portfolio?

It is a known fact that since the fall of international gold prices in the early 1980s, it took more than 25 years for gold to reclaim the levels of what was seen in that decade. But since then, gold prices have shot up and the gold investment has delivered positive returns. In fact, in the last 18 months, gold has delivered a return of 53% beating almost all the global indexes. This is similar to what is being historically seen in some quality stocks globally. Apple Inc. has delivered negative returns for 20 years starting from 1983 to 2003, but since 2003, it has delivered returns more than 300 times. Reliance Industries has given a negative return for more than 8 years starting in 2008, but since 2017, the stock price has shot up significantly.

International gold prices

International Gold Prices
 Source: Tradingview.com

Before talking about the benefits of investing in gold, let us understand the technique with which one can invest in gold. Apart from physical gold, the simplest form of investment into gold is the gold ETF (Exchange-Traded Fund). Gold ETFs trade on an exchange offering passive investment into gold, while tracking the spot price of physical gold. 

Why Gold Is a Good Investment?

  • Diversification tool: The idea behind portfolio diversification is that there should be very little or no correlation between financial instruments and products. Historically it has been proven that gold has a negative correlation with equities and fixed income instruments. The year 2008, which witnessed the global financial crisis, was superb for gold but disastrous for equities everywhere in the world.
  • Hedge against inflation and protection against deflation: Historically, during the periods of extreme inflation, gold prices have risen and the stock markets, globally, have crashed. With high inflation, the local currency loses its purchasing power but gold tends to hold the value and rise against the domestic currency. During the episodes of decreasing prices, that is deflation, people tend to hold liquid cash as well as gold, soaring the price of the yellow metal.

Performance of Gold during periods of high inflation

Performance of Gold during periods of high inflation
Source: World Gold Council, Bloomberg Quint, Tavaga Research
  • Safe Haven Asset: Demand for gold rises during geopolitical uncertainties, pandemics, and crises as physical gold which is a high-value asset, can be easily transported, and also liquidity is such that it can be easily converted into cash in any part of the world.
  • Demand and Supply Factor: Continuous supply of gold is difficult as extracting gold from mines is a multi-year exercise involving a lot of efforts, but demand for gold can shift in no time depending upon the economic conditions and thus fluctuate.
  • Liquidity: The globally accepted commodity which is bought and sold in huge volumes, can be easily converted into cash, making it liquid.

Gold is one of the most liquid assets traded in the world

Gold is one of the most liquid assets traded in the world
Source: Bloomberg, World Gold Council, Tavaga Research

How Much Gold Should an Investor have in his/her Portfolio?

Now that it’s clear as to why gold should be a part of the investment portfolio, the next important step is the percentage of allocation. It should be noted that there is no specific ratio or a perfect method to calculate the allocation of gold in one’s portfolio. However, historical evidence suggests that along with the percentage of allocation, the reason for allocation is equally important. 

  1. If one invests in gold to achieve portfolio diversification, then historically it has been seen that a 10%-20% allocation does reduce the average returns slightly, but it significantly reduces the standard deviation. A greater allocation (more than 20%) towards gold reduces the average return substantially but unlike the above situation, the allocation fails to reduce the standard deviation.
  2. If one invests in gold from a safe haven perspective, there isn’t a simpler way to quantify the allocation of gold, but a wide range of 5%-20% is considered, depending upon the economic conditions. 

While it is true that historical perspectives are used many times in the above article, they should only be used as guidance to invest in the future.

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