Is investing in gold a good idea ?

The table captures 5-year and 10-year returns for gold and the Indian equity market between 1997 and 2007 on a rolling basis, at monthly intervals. Equities have delivered superior returns, with a lower possibility of losses over this period. Gold prices are London prices, in dollar terms.
*No. of months investor would have made a loss, out of total.

After a long wait, Indian investors finally have the means to "gild" their portfolio when they draw up their financial plans. With gold Exchange Traded Funds making a debut in India, you no longer have to visit the local jeweller, fork out making charges/wastage and take your chances on caratage when you buy gold.

Instead, you simply buy ETF units and hold them in your demat account, and you can be sure that your investments will closely mirror trends in global gold prices. But is investing in gold really a good idea? What return expectations can you have from the precious metal, if you hold it for the long term? We analysed monthly gold price trends for the past 10 years in the global and Indian markets, to arrive at some answers. Gold, in the global context, has delivered a compounded annual return of 6.6 per cent over the last ten years. The return for Indian investors in gold has been a shade higher, at 6.9 per cent (all returns annualised), mainly as a result of the depreciating rupee.

Expect modest returns

If this seems like a decent, inflation-beating return, do note that you would have earned this return only if you had managed to time your investment rather nicely to end-March 1997, and had held on till date. The recent ten-year window has been a particularly good one for gold, with rising oil prices and a weakening dollar prompting investors to rediscover the metal as an investment option. For those who didn't display such a fine sense of timing, long-term returns from gold have been much more modest.

If you invested in gold with a 10-year horizon sometime between 1987 and today, your returns could have ranged anywhere between a negative 4.8 per cent and a positive 6.7 per cent annually, depending on the month of initial purchase. In comparison, equities appear to have a much better track record of delivering long-term returns, irrespective of the timing. The minimum 10-year returns the Sensex managed between 1997 and 2007 is a negative 0.14 per cent; while the maximum return was as high as 24.7 per cent.

Message: If you are a long-term investor, gold, obviously, cannot substitute equities in your portfolio. In the Indian context, gold has an inferior track record to equities, both in terms of return potential and the probability of losses. Use gold as a supplement to your equity portfolio.

Five years better than ten?

When you buy equities, you are usually urged to hold on to your investments longer if you would like to improve the return potential. But evidence of the past 10 years shows that gold has delivered better returns if held for five years rather than 10. The best five-year return managed by gold between 1997 and 2007 was 19.7 per cent. This is much higher than the best 10-year return of 6.7 per cent. In equities, a shorter holding period pegs up the chances of earning negative returns on your investment.

But if history is any indication, the reverse has been true for gold. Investors who held gold for five years registered negative returns on fewer occasions (5 out of 10) than those who stayed invested for a 10-year period (6 out of 10)!

Message: Invest in gold with a 5-year horizon.

Likelihood of losses

Gold is generally preferred for its "safe-haven" qualities; it performs well when investor confidence in other asset classes such as equities is at a low ebb. However, this does not mean that your investments in gold protect you from losses.

Going by the record of the past 10 years, the probability of losing money on gold is fairly high, even if you stay invested over a five- or 10-year period. For 10-year holding periods, gold has delivered negative returns on 77 out of 122 occasions between 1997 and 2007. It has delivered negative returns on 64 out of 122 occasions for five-year holding periods.

Whatever the investment horizon, the odds of earning a negative return on gold appear higher than those on equities, going by the experience of the past 10 years.

Message: Gold is not a substitute for your safe, fixed return investments, such as bonds.

If gold has only moderate return potential and can erode in value over long horizons, why at all should one consider investing in gold, you may ask.

The case for gold

There are three key factors that support investments in gold:

Diversifier: Gold could be a stabilising influence on your overall portfolio. Trends in monthly returns on gold over the past 10 years show that gold prices seldom move in sync with returns on other asset classes, whether equities or debt. This makes the metal a good portfolio diversifier.

The correlation of monthly returns on gold with the Sensex over the past 10 years is at a negligible 0.06. Though this correlation has risen to about 0.2 in the recent five-year period, it remains statistically insignificant.

This means that if you hold both gold and equity investments in your portfolio, there is a negligible chance that values of both will decline at the same time, making a big dent in your net worth!

This is also borne out by anecdotal evidence. Gold was among the best performing asset classes just after the tech stock meltdown of 2000-01. Gold prices actually appreciated about 4 per cent in the aftermath of the dotcom bust between March 2000 and October 2001, a period when the Sensex lost a whopping 48 per cent in value!

During the recent corrective episode in May-June 2006, gold prices did peak out at the same time as stock prices and fell when stock prices did. However, the magnitude of decline in gold was much lower than that in equities.

Though gold has historically displayed a low correlation with equities and other assets, investors in gold need to be aware that this relationship could change in the years ahead.

There is a view that the commodity, currency, equity and bond markets across the world are developing stronger inter-linkages due to their dependence on liquidity from large institutional investors (read hedge funds) with a presence across markets and asset classes. Episodes such as the May meltdown (which encompassed stocks, commodities and gold) seem to support this view.

Less volatile: Though gold has offered lower return potential than equities, it has also witnessed lower volatility from month to month. Based on monthly returns for a 10-year period, gold prices have displayed significantly lower variation (standard deviation) than the Sensex.

Similarly, though gold has frequently registered negative returns, the magnitude of decline has been much lower than that on equities. The worst monthly return for gold between 1997 and 2007 was a negative 9.3 per cent, while that for the Sensex was a negative 15.8 per cent!

Insurance against crisis: The above analysis uses historical data to provide a reasonable indication of what gold has to offer as an investment option.

However, in the world of investments, past performance may not always be an accurate indicator of future returns.

Though gold delivered a modest performance over the past 10 years while stocks and bonds have done much better, there are several risks that could materially alter this situation over the next decade.

Gold has traditionally been a sought after asset during periods of intense crisis — a spike in oil prices, a run on a currency, runaway inflation, and so on.

Holding a portion of your portfolio in gold could help you ride out phases in which other assets don't deliver — say, steadily rising inflation (which could hurt bond returns), spiralling commodity prices (which could hurt corporate earnings and thus stocks) or a withdrawal of liquidity from the financial markets (which could hurt the entire range of assets).