Why is Gold Valuable?
Last week, we published a blog “The Most Damaging Myths of Indian Investing” in which the first myth we attempted to bust was that Gold will help me protect my wealth. Earlier this week, Nick Maggiulli put out his weekly blog on the same topic – gold as an investment. Unlike Warren Buffet who has been critical of gold as an asset class for long, given its lack of productive use, Nick starts off with a defence of gold and its value citing scarcity, durability and malleability. But then he also highlights why gold by itself has been an inferior asset class versus equities not just because of the lower returns but also the higher risk. The latter does come across as contrary to popular perception – Nick shows that gold has the highest standard deviation among most asset classes.
“So, you want to own gold for the long run? If so, you better be comfortable with multi-decade drawdowns. If you aren’t, then welcome to the club. I used to be a gold investor myself, but sold out of it after I realized how difficult it would be to hold an asset over such long periods of time. Even with its price run in recent months, gold is still more than 5% off of its 2011 all time highs.
Additionally, gold has much more volatility with much lower returns than many other similarly-risky asset classes (i.e. equities, REITs, etc.).
As you can see, gold seems to break the pattern of “more risk => more reward.”
Lastly, gold also seems to go through periods of boom and bust, which can be hard for many investors to stomach.”
However, Nick makes a case for gold in the portfolio context i.e, by being able to improve the risk-return trade-off of the overall portfolio by being a component of it. He demonstrates that a portfolio with an equal split into three asset classes: the S&P 500 (33.3%), long-term U.S. bonds (33.3%), and emerging market stocks (33.3%) underperforms a similar portfolio but with gold in it i.e, S&P 500 (25%), long-term U.S. bonds (25%), emerging market stocks (25%), and gold (25%) – both in terms of returns and risk.
“The reasoning for gold’s ability to add value at the portfolio level is its low correlation to other traditional risky asset classes (i.e. stocks). For example, the average correlation of monthly returns between gold and the S&P 500 is basically zero though it has varied historically”
Why then does the analysis in our blog show a 12% positive correlation between Gold and equities? Our analysis takes Gold price returns in INR. A significant part of the returns Indian investors experience on their gold investment is actually the INR depreciation against the USD which in turn triggers the positive correlation. This, therefore for an Indian investor, perhaps suppresses the balancing effect of Gold on one’s portfolio as Nick has shown.