Ohh my Gold…!

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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Ohh my Gold…!

Part 1: A brief history

Gold is the only currency used in the history of mankind that has intrinsic value. Owing to its physical properties, gold (and silver) has been one of the first investment instruments. Gold is tangible, durable, non-reactive, non-corrosive, ductile and malleable metal. This has allowed division of gold in denominations as small as 0.5 grams. This divisibility is one of the reasons why gold (and silver) was used as currency during medieval time. Apart from ductility and malleability it is a good conductor of electricity due to which it has various industrial applications.

There are various emotional and behavioural aspects to why people want to invest in gold. In India and many other countries, gold is seen as a sign of prosperity. Gold fascinates people from all strata and income groups. Royals, monarchs, kings and rulers all over the world have always resorted to gold to fill up their coffers. Liquidity owing to universal acceptance is also an important property of gold that makes it desirable.

Before August, 1971 when Nixon de-linked US $ from gold, the greenback was supported by gold at a rate fixed by the US government. The events that lead to and after the shift from gold standard to fiat currency are portrait of how a financially engineered economy and currency system may fail. Let us go back in time and understand history of gold.

1920-32– Rate of gold in USA was ~$20 per ounce

1933– $35/ ounce

However, 1929 marked the start of global recession & deflation. This led then US President Franklin D. Roosevelt pass the infamous, historic order 6102 which gave a period of mere 25 days from 5th April to 1st May 1933 for all citizens of USA to exchange their gold coins, bullion and certificates for a fixed sum of $20.67 per ounce. In the following year, the gold exchange rate was revised to $35/ ounce effectively de-valuating the dollar by 40.94%. This is the only event of government confiscation of public gold (although for a price), an effort to fuel inflation that failed miserably and it wasn’t until the Second World War when things started moving again as desired (in terms of inflation).

1944Bretton Woods Agreement– This agreement abolished exchange of gold in international trade for exchange in US$ which was the reserve currency. Each of the currency was pegged against gold based on the amount of gold reserves with the country. IMF was established to monitor interest rates and currency stability whereas World Bank was established to lend reserve currency and facilitate trade. It is estimated that almost 75% of the then declared world gold reserves were with the USA.

1968-73– Some 20 years after the Bretton Woods agreement, countries other than USA were holding more US $ than the US gold reserves. This resulted in risk of lack of confidence and possible run on US $. Eventually the Bretton Woods agreement was abolished and all the world currencies were floated against US$ and countries are now free to choose any exchange agreement. This was the beginning of gold being traded as a commodity.

Present day scenario

Since 43 years the arrangement of fiat currency has survived, albeit for a few major crisis. Fiat money is simply a government approved legal tender used for transactions. This is however not backed by any commodity such as gold but by a promise of the government that issues it. Hence today, a currency is as strong as faith in the government that issues it. Devaluation of currency results in appreciation of gold prices. This is because gold prices are expressed in US$. Hence any weakness in US$ results in rally in gold prices. However this doesn’t mean that gold is comparable to US$ as an investment instrument. US $ is again a fiat currency and is only as strong as the faith in US government which is backed by its ability to impose taxes on US citizens. Hence ultimately a fiat currency is as strong as tax paying ability of citizens in the country of issuance.

To be continued.. (Part 2: Gold Demand and Supply)

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