We have a special attraction towards gold
We even call our kids “My gold”. We like gold that much. And for that reason alone, we have given a unique position for gold in our portfolio. But in reality, is gold a good investment? Does it help in building our wealth? This episode is to explain that in detail. We will not be able to let it go that easily. Most of the times, it works to our advantage and is for our own good. But sometimes, it puts us in a disadvantageous position. This topic of gold is like that as well. So let’s forget what we know about gold for now. Let’s erase everything and start from a clean slate. That will help in understanding gold better.
Let’s begin with reviewing the use of gold.
With the gold that is mined today, about 50% is used for making jewelry. 10% is used for industrial purpose. Because of its unique characteristics, we are using gold in electronics right? That is the industrial usage we are referring here. The rest 40% is used in investments. Like oil and gas, gold is also a commodity. The price of all commodities changes depending on the supply and demand. If oil supply goes down, its demand will go up. That will lead to rise in price. But for gold’s usage, its supply is well over the demand.
why its price is keep changing?
That demand is coming from investment. Whenever we get into an economic crisis, investors will run towards gold. Why? Does gold deliver babies during a crisis time? Not at all. Even during those crisis times, it just lays around the locker doing nothing. But during crisis times, everyone will be under a fear. “What will happen to our country? What will happen to our currency?” That fear is what drives people to find a safe haven in gold. If we have gold, even if our currency loses its value, we can use the gold for the exchange of any goods is the rationale. After seeing what happened in Zimbabwe and Venezuela, we can understand that rationale.
Now let’s check out the historical return of gold.
Gold is trading in US dollar in world market. So let’s check out how one ounce of gold has changed its value over the time. Depending on the period we are looking at, the return of the gold changes drastically. Gold was at a fixed price $35/ounce since 1934. This $35/ounce continued for next 37 years till 1971. In 71, then US president Nixon, dropped the gold standard and freed gold price from being tied to US dollar. After that, gold rose sharply to $850/ounce by 1980. The annualized return for those 10 years is around 31%. We can call that period as the golden period of the gold. For next 10 years, the price dropped to 400 something. The annualised return for that decade is -2.4%. The drop continued in 90’s. In next years, gold price dropped from $400 to $280. The annualised return for that decade is -3.3%. In the next decade starting from 2000, gold did a come back from $280 to $1100. Annualised return for this decade is 14.3%.
Annualised return for the next decade is 3.3%. Since 2020, the return for last 1.5 years is 10%. If we have stayed invested in gold for the past 40 years, our annualised return would have been at 3.4%. This is in US dollar – gold’s actual return. But in Indian rupee, the return for those 40 years is 8.5%. We already know the reason for that from our Asset Allocation episode. In these 40 years, the rupee has lost its value 9 times from 8 Rs/$ to 74 Rs/$. So the return in Indian rupee looks bigger. But that extra 5% did not come from gold appreciation. But from Indian Rupee losing its value against US dollar. “So, can we but gold to beat the index? All experts are suggesting that gold could be a good inflation hedge.” Yeah… but looking at the history of gold, it does not look that way. US inflation has risen on average of 4% per year from 1980 to 2000.
If gold is an inflation hedge, its price should have gone up during that period. But in that 20 years period, one ounce of gold has fallen from $850 to $280. That means, for a strong currency like US Dollar, gold is not a reliable inflation hedge. Depending on the weakness of a currency in the world market, gold will be a strong inflation hedge for that currency. Do you think Indian Rupee will get weaker in the future? or stronger? Depending on that, you can decide on whether you can have gold as an inflation hedge. “All that is OK. But gold is a safe investment. There is no reason to think twice for investing in gold…” Is that right? How safe is gold? How are we measuring the risk of an asset? We are measuring that using its volatility.
The measure of how far the price of an asset is moving up and down is volatility. Volatility of gold is higher than that of stock market index. If we look at the volatility of S&P500 since 1975, it is at 15% where as the volatility of gold is at 19%. If we ask whether the gold has given a higher return for that kind of volatility, the answer is No. In that period, S&P500’s annualised return is 12.3% where as the return of gold is 5%. So why would someone take a higher risk for an asset that gives lower return? Good question. Why are we investing in an asset? Because, we are expecting a future cash flow from that asset. For bonds – its interest, for stocks – its dividends, for real estate – its rent etc. So for every asset, we are assigning a price depending on its future cash flow potential and we are investing in them. But for gold,
There is no future cash flow.
If we buy 1 ounce of gold for investment, it will be the same 1 ounce for ever. “No boss. You yourself mentioned. We can make jewelry out of gold”. If jewelry is our need, we can definitely buy gold. Nothing wrong with that. But the question here is whether gold is an investment. If investors come to know that the future cash flow of an asset is going to rise, then they will be ready to buy that asset for higher price. That is how an asset appreciates in its value. But as gold does not have any future cash flow, the only hope of the gold investors is that they can find another person to buy it for a higher price. In that regard, this is just like a bitcoin. But the surprising thing here is, gold supporters oppose Bitcoin. And Bitcoin supporters make fun of gold investors. Except for few like Warren Buffet and Charlie Munger, not many acknowledge that they both are equally bad as investment. Does that mean that we should not be buying gold at all? No. Not at all. We can definitely buy it. But buying it for the purpose of investment is a questionable decision.
So who should buy gold? If you like gold jewelry, then sure, you can buy it. If you don’t believe in your country’s currency, then to minimize that risk, you can definitely buy it. Other than these, knowing that during an economic crisis time, stock market will go down. Gold in portfolio will give a cushion to handle that blow. For that cushion, if you can let go off of some of your long term growth – then you can buy gold as well. Also folks who is trying to save gold for their daughter’s wedding, can buy gold as well. But I would question, why we should give our girl to someone who is demanding gold. But that is everyone’s personal choice. Folks who are focused on building their wealth, should not by gold.
As gold does not have the return potential for the amount of risk we take, it is better to invest in an Index fund. This is my opinion. But for your own happiness, you can have upto 10% of gold in your portfolio. Nothing wrong with that. After all, this is personal finance. Make it personal depending on your choices. If you have decided to buy gold, Sovereign Gold Bond is a good option. Remember, I told that gold does not have future cash flow? But this one gives 2.5% interest. Also as it is issued by RBI, it is lot safer too. So if you are planning to buy gold for long term, you can definitely consider Sovereign Gold Bond. Next, let’s get into the question from last episode. Two funds following Nifty 50 Index – Fund A and Fund B. Both have the same characteristics like expense ratio, tracking error etc. The only difference between those two is price. Fund A – Rs.100, Fund B – Rs.10.
Which one of these funds will you invest?
This is the question. Many answered right that there is no difference in returns between these two. Some assumed that this might be a tricky question and answered with fine differences. This is not a tricky question at all. Simple and straight forward question. For this question, about 50% of the responses chose Fund B because we can get more units. So the returns will be more. Dividends will be more as well. Let’s see why that is a wrong understanding in detail. Let’s say that there is a tea shop. Tea Shop A. The value of this tea shop is Rs. 10 Lakhs. Let’s say that this business is divided into 10 shares and offered to investors with a value of Rs. 1 lakh per share.
There is another tea shop very next to this one. Tea shop B. This is exact copy of tea shop A. Same characteristics. That is, same sales and same profit. The value of this tea shop is Rs. 10 lakhs as well. But this business is divided into 100 shares and offered to investors with a value of Rs. 10,000 per share. Now let’s say that I have Rs. 2 Lakhs. I am investing 1 lakh in Tea shop A. I get one share of Tea shop A. I am investing the other lakh in tea shop B. I get 10 shares of tea shop B. My invested money is same in both the scenarios. But the number of shares that I got is different from each shop. Let’s say that after a year, both the tea shops have earned a profit of Rs. 1 lakh. This one lakh profit is shared among the share holders.
How much does each share on tea shop A get? 1 lakh divided by 10, Rs. 10,000 will be given to each share. I have one share of tea shop A. So I will get a profit of Rs. 10,000. Tea shop B has the same profit of Rs. 1 lakh. If that is divided among 100 share holders, how much does each shareholder get? Each gets Rs. 1,000. How many shares do I have? 10 shares. Then how much money do I get? The same Rs. 10,000 as in tea shop A. Did I get any extra profit because I had 10 shares instead of 1 in tea shop A? NO. This is the same concept that differentiates between Fund A and Fund B. Nothing will be different from the returns from these funds. Both would have given the same return. Shares work like this in the share market. The price of the share and the number of units is not important.