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Aarati Krishnan

WOULD you have guessed that the best performing investment in your portfolio over the past year was the gold stashed away in your bank locker? Domestic prices of the precious metal have appreciated 27 per cent since January 2002. In comparison, the average equity mutual fund returned 17 per cent, and bond mutual funds 12 per cent.

In recent months, gold has made a global comeback as a "safe haven" investment. A weakening US economy, the depreciating greenback, tumbling interest rates and fears of a spike in oil prices have sent investors scurrying to gold. The resurgence in gold prices has revived some of the age-old arguments in favour of investing in gold.

Gold lobbyists point out that gold is the only asset that offers a combination of benefits — an effective hedge against inflation, a good diversifier in a portfolio comprised of stocks, bonds and other traditional assets, and instant liquidity. In the developed markets, many of these arguments in favour of gold are supported by numbers.

But does gold hold promise as a source of long-term investment for Indian investors? Not really, if the returns on domestic gold prices over the past 10 years are anything to go by. Gold prices in India have not behaved quite as economic theorists would have it.

In the 1970s and 1980s, with imports of gold strictly regulated, domestic gold prices reflected the interplay of factors such as domestic inflation, stock market performance and demand-supply dynamics. But with the relaxation of controls on gold imports from 1990, domestic influences on gold prices have waned and Indian gold prices have aligned closely with international levels.

As a result, gold prices have been determined more by landed costs and by the rupee-dollar exchange rate, than by the performance of alternative investment avenues within India. Since the bulk of gold consumed in India is imported, this trend is likely to continue.

Inflation hedge

Indian investors who held a significant portion of their assets in gold in the 1990s would have found that inflation has steadily chipped away at the value of their assets.

Since 1990, gold has proved a very poor hedge against inflation. In fact, the annual returns on average gold prices have trailed the rate of domestic inflation (measured by the Consumer Price Index for Urban Employees), in 11 of the last 13 years, by a wide margin.

When you consider that the official inflation numbers do not really capture the price rise in commonly used consumer products and services, gold's appeal as an inflation hedge dims even more. What is more, unlike the 1970s and the 1980s, when prices of the yellow metal clearly responded to a sudden spike in inflation, prices in the 1990s barely moved during sharp spurts in the CPI.

Diversifier

A traditional argument for holding gold in your portfolio has been that it has a low correlation or is negatively correlated to most other financial assets, such as stocks, bonds and treasury bills. Therefore, even if the stock and the bond markets fall in tandem, you can still be sure that your holdings of the precious metal will lend stability to your portfolio.

Indeed, Indian gold prices and the stock market did appear to have an inverse relationship until the end of the 1980s. Gold prices appreciated sharply during the stock market reversal of 1987-88 and generated modest returns during boom years in the stock market (such as 1985-86 and 1988-89). But this relationship has gone awry in recent years. When the stock market (represented by the BSE Sensex) lost 14 per cent in value in 1998-99, gold too posted negative returns.

Though the stock market shed 47 per cent in value between February 2000 and September 2001, gold prices barely changed between these dates. In 2002, both gold prices and the stock market moved in the same direction, registering positive returns.

Gold in your portfolio

Gold may appear to be a good addition to your portfolio as domestic gold prices are dictated by an entirely different set of factors from those influencing the financial markets.

An analysis of monthly returns on gold prices over the past eight years, relative to the Nifty, shows that the former had an insignificant correlation (of 0.004) with stock market returns and a low negative correlation (minus 0.1) with interest rates on bank deposits. (On the other hand, domestic gold prices had a high positive correlation with London prices).

Gold prices have also been far less volatile than the Nifty (the standard deviation of monthly returns on gold prices has been half the level in the Nifty).

Stability, at the cost of returns

So would the addition of gold be a good stabilising influence on your portfolio? It may have helped weather the stock market meltdown better.

For instance, had you invested Rs 1,00,000 in the Nifty basket of stocks in December 1996, the value of the investment would have swung between Rs 93,927 and Rs 1,57,950 in the seven years to January 31, 2003.

On the other hand, had you started out with a Rs 80,000 invested in the Nifty basket and Rs 20,000 in gold, the value of your investment would have fluctuated much less from year to year. The range, in this case, would have been Rs 95,036 to Rs 1,48,287. This is not all.

Thanks to the surge in gold prices last year, you may have ended up with slightly higher returns on this mixed portfolio than you would have on one comprised solely of stock from the Nifty basket.

However, a 20 per cent allocation to debt (through a bond mutual fund or through bank deposits), instead of gold, would have given you much better results than from gold.

Instant liquidity

The "liquidity" argument for gold does not hold much water either. Yes, being an universally accepted store of value, you can convert your gold holdings into cash in a distress situation. But the realisable value of your gold holdings may be much lower than your investment on two counts.

For one, if you hold your gold in the form of jewellery, the buyer may subtract 10-20 per cent of the value as adjustment for low caratage, wastage and other charges. But, more important, unless your purchases and sales are well-timed, you may face a significant erosion in the value of your investment when you want to liquidate it.

For instance, an investor who bought gold in 1996 would have not been able to liquidate his investment at a profit in any of the years between 1996 and 2002. Domestic gold prices, which hovered at Rs 5,060 (per ten grams) in 1996, never crossed the Rs 5,000 mark until March 2002.

In fact, after registering a positive return in each of the 20 years between 1970 and 1990, returns on average gold prices have faltered in the last ten years, and were negative in three of the last ten years. Over this 10-year period, the timing of purchases and sales emerged as a key determinant of the returns earned from gold holdings.

For instance, a person who invested Rs 1 lakh in gold in December 1996, would have found that his investment was worth Rs 1,14,747 by end of January 2003. But if the investor has actively managed his gold portfolio, buying at the lowest price and selling at the highest, he would have been rewarded with much better returns. His investment would have been worth Rs 1,64,680 by the same date.

Timing still important

Chances are, despite all of the failings listed above, we will continue to hold and buy gold, at least for use as jewellery. The message for such investors is: If you do plan to invest in gold, do apply the same principles that you would for any other investment.

Try to time your purchases to low levels in gold prices and take advantage of sharp price spurts to liquidate part of your gold holdings. Doing this may not earn you handsome returns on your investments in gold. But it may help protect your holdings against an erosion in value.

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