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Part 3: Gold as an investment instrument

There is no doubt about gold being a ‘store of value’ and its role in ‘wealth preservation’. However yet it’s utility as an investment instrument is often questioned but seldom is its utility as portfolio insurance.

Gold price movement since the end of 1969

Gold appreciated at CAGR of 10.18% in past 47 years till Oct’2016. However the rate of appreciation from 1st Mach 2001 to 1st March 2008 was 32% and as the subprime crisis finally unfolded upon us, value of gold doubled in the following 3 years.

Remarkably gold price went up by 18x during hyper inflationary scenario of 1970-80. At the onset of 21st century, George Bush’s ‘housing for all’ resulted in rising inflation in USA this culminated into the worst financial crisis the current working generation has seen. Gold has shown stellar performance in this period as well. The data suggests that as an investment gold will still rank above many fixed income instruments.

Gold and Portfolio Diversification

Diversification calls for investments in different asset classes. An important element in diversification is correlation between different asset classes. An analysis by world gold council concludes near zero correlation between gold and either US equities or US T-bills for past 10 years. Amongst many other investment instruments, EM sovereign debt tops with correlation of just under 0.4 with gold.

From the commodity pack, silver has strong positive correlation with gold, followed by Dow Jones AIG commodity index; the later however will be biased by weights assigned to gold and silver.

Theoretically any asset class which has correlation of less than +1 with other assets or with the portfolio will entail the benefit of diversification.

Based on following graphs it can be concluded that gold will add diversification benefits to a portfolio. However this doesn’t answer the question of how much weight one should assign to gold.

Correlation between gold and other commodities

Weight of gold in a portfolio

People belonging to Austrian School of Economics have a very interesting perspective in this regard. So far it is clear that gold has performed well during the great depression of 1930s which was a deflationary scenario. It has stood up to the test of time during the hyperinflation or stagflation of 1970-80 and also during the crisis of 2008. This emphasizes gold’s importance as an insurance for the portfolio.

During 1930s, US equities saw deterioration of values in the range of 70- 80% whereas gold prices went up by 75%. However in real terms the purchasing power of gold increased by almost 10x due to devaluation of US $. This incidence has founded the basis for 10% asset allocation for gold in a portfolio so as to preserve your purchasing power.

During the hyper inflationary period of 80’s decade, gold went up by 18x and it went up by 7x from 2001 to 1011 the decade marked by sub-prime crisis. It is thus evident that gold can be a good hedge against inflation and it lives up to its reputation as ‘store of value’ during deflation. Unlike many other commodities these movements however, are independent of the demand and supply of gold. These are results of behaviour of masses resorting to gold during panic periods.

This behaviour underlines how current credit fueled monetary system is vulnerable to the sentiment of masses and trust in the central banks globally. Current negative rate scenario is an absurd example of how financial systems are “managing” themselves with the fiat currency. Incidentally just like the fiat currency many other investment instruments are eventually backed by the faith in government’s ability to collect taxes and not any tangible thing that has value.

To fight the financial crisis which is resulted from credit fuelled economy central banks resorted to printing more notes i.e. more liabilities. This may one day eventuate into lack of faith in the fiat currency and collapse of the system as we know of it. With this outlook Austrian School of economics advocates 10% allocation of gold preferably in the physical form as the electronic gold, though backed by reserves is again a mere promise.

Yes! It is a frightening picture of the future but it’s just a possibility and the chances of this happening is a guesswork. The best thing an investor do is forget the risks one has already transferred and work around the risks that one has decided to take.

But Always Invest because “Hope Floats and Cash Flows!”

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