You’re hooked on gold. The 54% 1-year gold returns leaves equity in the dust. There is a new sovereign gold bond issue that’s open now. And with enough clouds on the global and domestic equity horizon, you want to include gold in your investments. Should you?
Well, why not start with what the data tells us? Understanding how gold returns have panned out and what drives it will help you know if and how to use gold in your portfolio.
Trend #1: Gold can be flat for years together
Gold, on its own, has no inherent investment return. That is, unlike a stock or a bond, it generates no cash flows in the form of profits, dividends, or interest income. Gold derives its returns from stress in other asset classes – namely equity, and debt. And equity gets into a risk-off mode when there are crises at hand, such as the global financial meltdown and now the Covid-19 pandemic. We covered the price drivers for gold in greater detail in this article.
In times when equity and debt markets are steady or strong, gold is not going to deliver. See the table below. It shows the proportion of times gold returns have been below 5% since 1990.
As you can see, the gold return rate is low to negative a third of the time in the 1, 3, and 5-year periods. So if you held gold, you would have seen that part of your portfolio returning virtually nothing relatively often in such periods.
So why the frenzy? The next trend will explain.
Trend #2: Gold rallies big
Gold, as you know, is a safe haven along with the dollar. The correlation between the Nifty 50 and gold in 1-month, 3-month, and 6-month periods in the past two decades are -0.01, -0.04 and 0.05, respectively. That means it has a negative-to-very-low correlation. So in times of global equity stress, as equity markets move into a steep correction, the gold return rate moves the opposite way.
As equity markets get more volatile, gold’s inverse relationship with the market increases which further feeds into gold returns. Therefore, when gold returns rise, it can shoot higher very rapidly and by very large margins as we are seeing now. These price surges can more than make up for the flat returns in the preceding years. From early 2015 up until mid-2019, 5-year gold returns were usually less than 5%. But with gold turning up from 2019, the 5-year returns are now above 16%.
The graph below shows the calendar year returns for gold. The years between 2008 and 2011 saw gold steadily delivering well as a fallout of both the global financial crisis and the resultant sovereign debt issues for some European countries. In this period, central banks too began piling on gold to maintain a reserve driving up demand and prices. Since then, gold has been flat until the current crisis. The past years since 2008 have also been a great period for gold in general, given the multiple global market risk-offs, which has influenced the return figures to an extent.
This shows that a few years of good returns will help pull up longer period returns. Gold’s highest 1-year return since 1990 was 77.6%. Returns have been above 20% a quarter of the time. All this suggests that when global equity markets move into a correction zone, gold prices react positively. Stress in the dollar, as we’re seeing now, can further add to gold’s allure in times of volatility. But does this mean gold is not volatile? Trend #3 explains this.
Trend #3: Gold can deliver losses as much as equity does
And be nearly as volatile. Going by deviations in gold return rate over different timeframes, gold returns can fluctuate in a manner that is similar to equity, though the extent of volatility is lower. However, this volatility evens out over time, also like equity. Over longer time periods, gold does not slide into losses; as we have seen, bursts of strong returns helps mitigate the effects of sub-par returns. The graphs below show how volatility and instances of losses between gold and the Nifty 50 compare over different time frames, since 1990.
So given that gold returns can be low to negative, while also volatile, what can you really expect from gold? Move on to trend #4.
Trend #4: Long-term returns have been 5-12%
With all these flat periods and surging periods, gold’s overall return has tended to be mild over the years. The table below shows returns of gold in different ranges for the 1, 3, 5, and 10-year periods. Returns have been taken from 1990. As you can see, gold returns have generally been in the 5-12% range most of the time. Returns averaged out to just under 10% over the years. For long-term portfolios, therefore, holding the metal is likely to deliver more or less reasonable returns.
In short – gold can be as volatile and as loss-making as equity. However – it behaves in the opposite manner and therefore will perform when equity does not. Holding gold over the long term has not resulted in losses and usually, returns have been somewhat reasonable at between 5-12%.
So, how can you use gold as an investment? Going by the data above, the takeaways are as follows.
- Gold can be very uncertain. Since the big rallies that deliver well depend on risk-off situations in global equity markets and the dollar, it can be very hard to predict when that happens or how long the rally will last. Therefore, while it makes good sense to make tactical gold investments, actually timing them right in terms of both entry and exit is tricky.
- While gold may seem attractive to include in your portfolio as a hedge, you need to avoid having high allocations for period less than 4 years for the following reasons: one, loss probability is high in such periods. Two, if gold prices go nowhere in these years (as we have seen already), that entire part of your portfolio is not going to deliver. In short-term periods, your returns are already going to be on the more conservative side as your risk-taking capacity here is low. Hence, while some allocation can be a great hedge against equity volatility, excessive allocation can also pose a risk. Three, for any period less than 4 years, your equity allocation should ideally be low and debt higher. Hence you don’t need any high hedge with gold.
- Gold is a good foil for equity in medium and long-term portfolios (4 years and above). If you have a very long-term portfolio, timing matters lesser here. Since it performs when equity does not, it helps contain downsides and lowers overall portfolio volatility. Keep such allocation up to 15% of your portfolio; the reasons given in point 2, such as periods of flat performance, hold here too, as well as the fact that gold returns are not high enough to warrant a large allocation. Here, reduce equity allocation in favour of gold. Do not reduce debt allocation. For instance, if you had an 80-20 equity-debt allocation, you can have a 70-20-10 equity-debt-gold allocation.
We had published a brief Q&A on whether or not to invest in gold earlier this year, as well.
How to invest in gold
- For tactical calls – Gold ETFs work the best. They allow you to invest in gold at the price desired and exit as well. Refer to Prime ETFs for our recommendations on which ETF to buy. While gold funds also offer liquidity and timed entry/exit, they have two layers of costs – one, the fund’s own management fee & expense ratio and two, the ETF’s expense ratio as all gold funds invest in gold ETFs. If you do not have a demat account, then you can use gold funds.
- For long-term allocations – Gold sovereign bonds work well here. The capital gains exemption and the interest component ensures returns higher than gold ETFs/funds. However, you will need to wait for the issue of a new tranche. While you can pick up the bonds in the secondary market, volumes are low. Reinvest the maturity proceeds of the SGBs back into gold funds/ETFs to maintain your portfolio’s gold allocations, if your time horizon is longer than the SGB maturity. If there are no SGBs available or you want to invest through SIP, then opt for gold ETFs/funds. We have a detailed ETF vs SGB comparison here.