Should you use Sovereign Gold Bonds to diversify your portfolio?

You can invest in SGBs as an additional investment but not to diversify your portfolio. The illiquid nature of SGB investments defeats the idea of regular investment diversification.

Abeer Ray, MintGenie Team
Published3 Jul 2023, 08:36 AM IST
Even gold as an asset has its limitations.
Even gold as an asset has its limitations.

The first tranche of Sovereign Gold Bonds (SGBs) for the financial year 2023-24 is available from June 19 to June 23 this year. With gold prices going up at an increasing rate in recent months, many investors want to know if they can invest in SGBs to diversify their investment portfolios. No doubt, gold serves to hedge against sudden market downturns, but is this enough to buy gold bonds and hold them for eight long years?

You cannot churn gold investments

The idea behind investment diversification is to churn investments regularly or in tune with market movements to reduce portfolio risk. However, this also means that investments must be inherently liquid so that investors can redeem them when necessary and reallocate the earnings to a better investment option. However, you cannot do the same with these bonds though some investors may consider selling them in the secondary market, albeit at a price lower than the prevailing market rate.

To achieve investment diversification, it is essential to sell non-performing or low-yield assets at a fair market price. This allows for the rebalancing of the portfolio, thereby resetting or adjusting the asset allocation. You can never sell these SGBs midway, thus, defeating the idea of diversification.

However, some investors argue in favour of its decent, tax-free returns. Is this reason enough to include gold in your investment portfolio?

Basavaraj Tonagatti, a Certified Financial Planner, SEBI Registered Investment Advisor, and a Finance Blogger at BasuNivesh explained, “Many assume that adding gold will create a well-diversified portfolio and a hedge against inflation. However, if you look at the past data, even though there is a negative correlation between equity to gold, this comes with volatility risk equally like the equity market. If we consider gold as a hedge against inflation, the correlation between inflation and gold price movement is very low. Hence, I strongly suggest staying away from considering gold in investment portfolios.”

There is no fixed formula to determine when you may diversify your portfolio. You may insist on diversifying your portfolio once or persistently diversify it to shield your investments from market-related risks. However, this also means that you must churn your investments other than gold owing to the latter’s relatively illiquid nature.

Inconsistent returns

When it comes to buying and holding an SGB until maturity to earn returns from gold, the potential range of returns is so vast that it bears a striking resemblance to gambling.

A look at the history of gold and the rolling returns from this metal in the past 30 years reveals that the returns from gold have always varied between seven and 12 per cent compared to equities that have served double-digit returns in the past. While the risk in gold investments is high, the quantum of returns earned from the purchase and sale of this metal via bonds is not enough to justify its purchase and inclusion for a prolonged period. The reward does not commensurate with the risk taken.

Also, gold returns depend on myriad factors like market position, currency equations, and the economy. The price of gold has been stagnant for many years before it moved to a new high. In some cases, it has also delivered negative returns. Unless for exceptional circumstances, gold prices do not go up exponentially as believed nor match the returns earned from the stock market.

Does gold really hedge against inflation?

The effectiveness of gold as a hedge against inflation has been a topic of debate, with varying evidence and perspectives. Some studies suggest a positive relationship between gold prices and high inflation, while others find no correlation or even a negative correlation.

There are several reasons why gold is often considered an inflation hedge. Firstly, gold is a tangible asset with inherent value. Unlike fiat currencies, which can depreciate as inflation rises, gold maintains its worth. 

Secondly, gold is relatively rare and scarce, meaning that its supply is not easily influenced by inflation. This characteristic makes it a reliable store of value during uncertain economic periods.

However, there are also factors that challenge gold's reliability as an inflation hedge. The price of gold is influenced by various other factors, including interest rates and investor sentiment. Consequently, gold prices can rise or fall during periods of low inflation. Additionally, gold is not a highly liquid asset, making it challenging to sell quickly during times of urgent need.

In conclusion, the evidence regarding gold as an inflation hedge is inconclusive. Different studies yield different results, with some indicating a positive relationship between gold prices and inflation, while others show no correlation or even a negative correlation. Ultimately, the decision to invest in gold as an inflation hedge should be made after careful consideration of the risks and potential rewards, as it is a personal choice.

Too high inflation rates cause the Central Bank to tighten its repo rates, thus, lending an adverse effect on stock prices. The stock market falls and people rush to move their money to gold citing how it would hedge against inflation. But, does gold really act as a hedge against inflation as popularly believed?

Viral Bhatt, Founder, Money Mantra said, “When the Central Bank tightens its repo rates in response to high inflation, the move can result in a decline in stock prices. This is because higher interest rates make it more expensive for businesses to borrow money, which can lead to lower profits and lower stock prices. In this environment, some investors may choose to move their money to gold as a way to protect their wealth from inflation. However, it is important to remember that gold is not a risk-free investment, and its price can also fluctuate.”

Hiren Thakkar, Chartered Accountant Proprietor, Hiren S Thakkar & Associates added, “One must not invest in gold purely based on the reason that the repo rates are higher and stock prices are falling. In the Indian context, gold generates its return as the rupee depreciates against the US dollar and changes in gold prices due to other factors. The aim must be to get inflation-beating returns over a longer time horizon than through the equity portion. Gold has too volatility and years of no return.”

You cannot diversify your investments unless you can redeem them or replace them with another. Also, every investor has a yearning or expectation from a particular investment. With gold, you never know if it would float or sink depending on future conditions. With SGBs, diversification is a tad bit difficult game, which is why some investors are adopting the tactical approach of putting some money in gold exchange-traded funds (ETFs) that they can take out at their will.

Gold shines and glitters, but one cannot be sure of how much sheen it would lend to one’s portfolio, especially, to those planning their investments with a long-term perspective while attuning it regularly to mitigate chances of losses in time.

 

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First Published:3 Jul 2023, 08:36 AM IST
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