Gold is a risk-stabiliser, not returns-enhancer

Recently, a certain industry association had a discussion on asset allocation and the debate turned towards gold. One question deliberated was: Is gold a good investment within a portfolio framework? The question assumes relevance because of the insatiable demand for the yellow metal in the country.

This article discusses gold investment as part of the asset allocation process. It first explains why gold is rationally sub-optimal investment. It then provides reasons to show why gold is a strategic investment for liability-driven portfolios despite the associated risk.

Rationally sub-optimal

For the purpose of this article, gold investments refer to investment in the physical asset, gold ETF and gold futures. It does not include gold jewellery and stocks of gold-mining companies.

Now, total returns from any investment can be decomposed into two sources- periodic cash flows such as dividend and interest income, and capital appreciation. An investment that provides returns from both sources moderates the asset price risk.

Take a high dividend-yield stock. Large periodic dividends cushion the decline in the stock price compared with a growth stock that pays no dividend.

Viewed in this light, gold should carry a high downside risk because the total returns come only from capital appreciation.

One factor that could moderate this downside risk is the demand-supply dynamics. World demand for gold for jewellery and other industrial use in 2008 was more than the supply from mining production.

The difference was bridged by recycling existing gold. If the world industrial production increases, demand for gold could go up, which could moderate the downside risk.

Of course, this argument does not take into account two primary price drivers in the market-central banks and traders. A decision by the central banks to offload gold could cause the yellow metal to fall sharply. Likewise, a large build-up and unwinding of trader positions could cause the metal to swing wildly, causing high price volatility. Despite these factors, investing in gold may be optimal.

Risk stabiliser

Gold acts as a safe-haven or “flight to quality” investment during geopolitical conflicts and financial crisis. The sharp increase in gold prices during the sub-prime crisis is a testimony to this fact. This safe-haven factor makes gold a desirable component of a retirement portfolio. Why?

Suppose a retirement portfolio suffers sharp decline in value due to global crisis at or near the investment horizon. The portfolio will then fall short of the desired value at the horizon.

An exposure to gold can moderate the shortfall risk in such circumstances.

Then, there is the insatiable demand for gold in the country. This can be attributed to what behavioural psychologists call as affect. In this context, affect refers to the good feeling that a person gets from buying gold. This feeling, in turn, leads to a lower risk perception and a higher benefit perception, even when it is not warranted.

Affect can be attributed to the obligation to gift gold jewellery during marriage and to other social and cultural reasons well entrenched in the Indian society.

Given this requirement for gold, exposure to gold ETFs would be optimal in a custom-tailored marriage investment portfolio. This is a portfolio that an investor creates to meet marriage costs. Gold ETFs would help in meeting the liability- buying jewellery at the higher spot price.

Gold ETF exposure should be preferably taken through a systematic investment policy- buying on one or more pre-determined days every month. This takes away the need to time the investment.

Conclusion

Empirical evidence suggests that allocating 3-5 per cent in gold would improve the risk-adjusted returns of a portfolio.

The actual asset allocation process would depend on the risk appetite as well as on the current wealth structure of the individual.

Mass affluent investors should a higher allocation than the HNWIs. The reason is that gold is more a risk-stabilizer than a returns-enhancer.