The past five years have seen gold prices contract from the peaks seen in September 2011. However, in recent months, prices have increased. For the financial year 2016, domestic gold prices rallied about 11%, the bulk of which happened in the first three months of the year—it increased nearly 20% from January till April 2016. While this recent trend could make you optimistic about the trajectory of gold prices, stop and analyse the objective of allocating funds to gold.

Opportunity in gold

Gold is not a productive investment—it does not earn interest, rent or dividends. All you have is the expectation that over a period of time the price of gold will increase. This is supported by two factors. First, supply of gold is limited, and second, gold can be used and exchanged in almost its natural form, so its value as a natural currency is high. This makes gold equal to money. But would you invest in cash? Not really. Then why would you invest in gold? Here is where the first factor comes into play; supply of gold is limited, whereas more cash can get printed. This also explains gold’s relationship with inflation; the more the value of cash decreases, the value of the limited supply gold increases. The decreasing value of cash is measured by inflation, and hence, higher the inflation the more we find there is a demand for gold and its price increases.

For global economics, the price of gold is directly related to the value of the US dollar. So, when the dollar becomes more sought after, gold gets left behind, and vice versa.

In the past couple of years, global growth has picked up. More specifically, growth in the US economy has started to improve leading to its first rate hike after seven years in December. This gave strength to the dollar, and demand for gold weakened. However, now the US economy is back in uncertain territory, and gold is again sought after. “The recent reaction in gold prices is largely due to the weakness in the dollar," said Naveen Mathur, associate director for commodities and currencies business, equity research, Angel Broking Ltd.

After this recent 20% increase (international prices too have rallied in the last quarter), fears around global growth recovery are more or less priced in, and it is unlikely that gold prices will continue to move higher sharply. Nevertheless, one has to watch out for risks such as crude oil prices.

Asset allocation

The recent correction in gold prices, which lasted over four years, has taught us that there can be a bubble in ‘safe’ assets as well. Before its correction, gold prices rallied three times in six years up to September 2011. It overshot its objective of providing an inflation hedge and provided returns equivalent and sometimes more than what risk assets did. Nevertheless, gold prices display a negative to neutral correlation with risk assets such as equity.

“Ideally, investors should have some allocation to gold because when assets like equity underperform, gold could do well. In terms of allocation, you can look at 5-10%. When sentiment in the capital market is negative, exposure to gold can be made closer to 10%; else it can be kept closer to 5%," said Lovaii Navlakhi, founder and chief executive officer, International Money Matters Pvt. Ltd.

Remember that the supply of gold is limited, and this, along with the production cost, is likely to put in place a floor price, limiting the downside.

“At the moment, supply is not an issue, and it could flatten out in this year. But price performance may not be as much as in the past few months if risk assets perform. However, there isn’t too much downside either given the global context of low interest rates. In India, as the jewellers’ strike has ended, demand could start picking up," said Harshal Barot, analyst-commodities, Motilal Oswal Financial Services Pvt Ltd.

So, there is reason to have some allocation towards gold for diversification, but avoid over-allocation.

“If you had bought more gold over the past year or so when prices were low, it would make sense to book some profits. But there is no need to take an active allocation to gold; maintain your strategic, passive investment," said Navlakhi.

Over the past 10 years, like other assets, gold prices, too, have been volatile. For FY17, prices are expected to be in a range of $1,200-1,350 per ounce, and domestic prices should follow suit along with the currency impact. If the rupee depreciates against the dollar, gold prices in India could move up, but it will be a technical adjustment rather than real value.

So, it is best for you to continue with what you hold, and if you are over-allocated in gold, use the rally to pare exposure.

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