GOLD SAFE BUT NOT SO SAFE

There are confusing signals regarding gold as an investment option. On the one hand, there are reports which predict a price target of $2,000 an ounce for gold. On the other hand, there is already a feeling that a bubble is building up in gold given the slack demand. My questions are: How does one plan investments in gold? Given that the prices are at their heights now, what would be a good time to start an investment? Is SIP the recommended approach? Between Gold ETFs and mutual funds investing in gold mining companies, which is better, and why? Usually, gold and stock prices have an inverse correlation; so, if we assume that the stock market is going to rise say in the next two or three years, what then happens to gold investments?

Unlike stocks, where it is possible to arrive at a price target based on a company’s earnings potential, there is no scientific method to arrive at a “fair price” for a commodity. Commodity prices are purely a function of demand and supply factors, with the speculative element usually adding to the momentum on either side.

The prediction that gold will head to $2000 an ounce is thus based either on the study of charts (technicals) or on the fact that gold prices last peaked at $873 an ounce during the oil crisis of 1980. Adjusted for inflation, the 1980 peak equates to $2,500 at today’s prices. As is the case with all predictions, this one too is not foolproof.

Not so safe


Though gold has emerged as full-fledged asset class in recent years, it is a myth that gold is a “safe” investment or that it delivers steady returns. With gold prices remaining extremely volatile, investing in gold today for quick gains, requires as much of timing as do stocks.

Over the past year alone, gold prices have swung between a high of $1,030 and a low of $730 an ounce; that tells you that investments made at high prices in gold have eroded in value. If you are looking at regular or assured returns from your investments, fixed income options such as bank deposits are your best bet.

Gold’s ten-year returns, at about 7 per cent on a compounded annual basis, aren’t really superior to fixed income investments; and the yearly return has been far from consistent.

Only to diversify


Seen in this backdrop, we feel an investor should consider gold investments only for the purpose of diversification, based on the expectation that gold may protect the value of your portfolio during periods when stocks or bonds don’t. Therefore, you should look to gold, not for delivering a huge outperformance of stocks over the long term, but to make your portfolio more stable at times when stocks go through the wringer.

For instance, over the past one year, a portfolio 100 per cent invested in equity funds would have lost 41 per cent in value, but a portfolio with a 80:20 equity: Gold ETF allocation, would have contained the decline to 28 per cent, thanks to a 17 per cent gain in the Gold ETF value. Based on the above, we would recommend a 10 per cent allocation to Gold ETFs in your portfolio, if you already own stocks.

Yes, we do think this is a reasonable time to buy gold. Gold’s status as a safe haven investment has generally made sure that gold prices have shot up during periods of extreme economic distress or uncertainty. Based on this yardstick, it is a good idea for investors today to have some gold investments in their portfolio.

Economic data from the US, Europe and other Asian economies, as also India, has been getting steadily worse. The prospect of governments printing more fiat money to pump prime global economies also threatens to devalue paper currencies, which is a positive driver for gold.

Three key factors


The recent price history of gold suggests that three key factors may be needed for gold prices to deliver strong gains from here — a weaker dollar, renewed inflation fears and sustained investment demand. While higher gold prices tend to curb jewellery demand, this actually helps investment demand accumulation of gold by investment vehicles such as global gold ETFs.

If your objective is diversification and you want to make sure your gold holdings mirror global prices, Gold ETFs, traded on the stock exchanges, are the most cost-effective way to invest in gold.

Funds investing in gold mining stocks may have the potential to outperform physical gold, but they suffer from two disadvantages. Because of being a high-beta exposure to gold, they tend to suffer sharper swings (either way) than actual gold prices.

They therefore, carry a risk element that is as high as, or even higher than normal equities. Further, they may fail to mirror gold price movements during periods when equity markets are in the doldrums. In fact, that is precisely what has happened over the past one year.

Coming to the query on how and when to buy gold, a certain degree of timing is necessary to ensure a reasonable return from the metal. Over the past year, gold investments made at levels of about $800 an ounce have delivered good returns. For investors who cannot time their investments, we would suggest buying gold ETFs in small lots, much like an SIP in an equity fund, phased out over the next two or three months.