Home / Money / Personal Finance /  A bit of gold can help reduce volatility

In terms of investment returns, gold has stormed ahead of all other assets over the past year. The yellow metal returned 23.59% (prices in rupees per 10 grams) in the year ending 20 February. As fears over coronavirus escalate, the price of the precious metal has surged by 4% over the past month. However, generally, the returns from the metal are volatile. After crossing 30,000 per 10 grams in 2012, it stayed relatively flat for nearly seven years. Interest in it dipped further as equity markets surged after 2014. We tell you if it makes sense to buy gold and things to keep in mind.

According to data crunched by Kuvera, a mutual funds investing platform, for the period between 1990 and 2019, portfolio allocations to gold and equity in different ratios give different results. It compared a portfolio with 100% equity with portfolios with equity-gold splits of 90:10, 80:20, 70:30 and 50:50 (see graph). Kuvera used the Nifty 50 as a proxy for its equity returns and the price of gold per 10gm in Indian rupees. The average annualized returns over this vast time period showed that a 100% equity portfolio delivered the highest average annualized return of 16.8%. As the gold allocation increased, the portfolios gave lower and lower returns. These went from 16.2% in the 90:10 split to just 14% in the 50:50 split.

Graphic: Mint
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Graphic: Mint

However, at the same time, the volatility of the portfolio fell as the proportion of gold was increased. This volatility is measured by standard deviation, and this number dropped from 27% in the all-equity portfolio to just 16% in the 50:50 equity-to-gold portfolio.

This is because gold has relatively low correlation with equity. A low correlation means that the two assets do not move in step. One tends to do well when the other does badly. Kuvera placed the correlation between the two at just 0.25. A correlation of 1 implies movement of two assets completely in tandem, while a correlation of -1 implies movement in completely opposite directions. A correlation of 0.25 means there is only some movement in the same direction but mostly the two assets behave in ways that are unrelated to each other.

Gold prices go up in times of fear and economic distress, which push equity prices down. Gold also moves higher with inflation, while equities become volatile as markets fear interest rate hikes and a reduction in consumer demand due to lower purchasing power. Rising inflation reduces the purchasing power in the hands of consumers.

Should you invest?

Having an allocation to gold in the portfolio has not historically increased returns compared to equity. However it has reduced volatility in the portfolio, making it less risky. Although the data analyzed shows lower volatility even at allocations to gold of 30-50%, financial planners suggest a 5-10% gold allocation.

“Gold should be 5-10% of an investor’s portfolio. Its low correlation with equity tends to reduce portfolio volatility. It is also a good hedge against inflation. In the last two quarters, as inflation surged, so did the price of gold," said Amol Joshi, founder, Plan Rupee Investment Services.

It can be used for diversification too. Gaurav Rastogi, CEO, Kuvera, said, “Gold has a low to negative correlation with equity, especially during market crashes and disasters. This makes gold an effective portfolio diversifier. That gold denominated in Indian rupees has also returned about 11% CAGR over the past 30 years is just the icing on the cake," said Rastogi. The reference to rupee-denominated gold refers to the fact that India’s relatively high inflation rate pushes up gold more in rupee terms, than its performance in, say, US dollars.

Things to keep in mind

Costs: If you buy physical gold or jewellery, you will have to pay making charges. If you are keeping the asset in a bank locker for safekeeping, there will be a locker fee to pay as well. If you are investing via gold funds or gold exchange-traded funds (ETFs), there will be an expense ratio that you will have to pay to the fund house. For instance, Nippon ETF Gold BeES, one of the oldest and largest gold ETFs in India, has an expense ratio of 0.79%.

One cost-effective way to invest in gold is through the government of India’s sovereign gold bonds (SGBs). There is no cost attached and instead you get an annual interest of 2.5% for investing. These bonds have a tenor of eight years and track the price of gold, just like a gold mutual fund. However, you can’t buy more than 4kg of gold through SGBs per year.

Taxation: Returns on gold are made on the growth in its value over time and are, hence, taxed as capital gains. Such gains are taxed at the investor’s slab rate for holding periods of less than three years. For longer holding periods, the tax is 20% along with the benefit of indexation. Indexation takes inflation into account while computing taxable gains. In the case of SGBs, interest is taxable at the marginal rate. However, there’s no capital gains tax on the maturity value, at the end of eight years.

Neil Borate
Neil heads the personal finance team at Mint. A former colleague called them 'money nerds' and that's what they are. They cover topics like mutual funds, taxation and retirement, all to improve your chances of building wealth. Neil graduated with a degree in law and economics. He passed the CFA Level I exam and began his writing career at Value Research, a mutual fund research firm in 2016. He joined the personal finance team Mint in 2019. Everyday, the Mint Money Team tackles personal finance questions such as where to invest and where to borrow, through articles, charts and reader queries. They also have a daily podcast - 'Why Not Mint Money' and an annual ranking of mutual funds - the Mint 20.
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