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Why Should You Have Gold In Your Portfolio?

Can I invest in Gold? Is Gold a good investment? Should I buy physical Gold or paper/digital Gold?

These are common question that investors come up with. But are you asking these questions with the correct understanding of why Gold should be a part of your portfolio?

Gold is not an investment product where you invest money get stready returns over a longer period like FDs, Mutual Funds, Equity & Bonds etc.

Instead, Gold is a fallback currency, a hedging instrument against the local currency such as Rupees, Dollars, Euro, Yen etc. It is used for retaining your purchasing power when value of currency goes down. For those who don't know what hedging is, it's a way of protecting against loss of value of something that you have, using an alternative. In this case, Gold is a hedge against currency, meaning, you are protecting yourself against devaluation of the local currency. So, due to a financial crisis, if inflation causes a ₹Rs. 20 water bottle costing you Rs. ₹20000, the currency becomes meaningless and you need an alternative way for transactions where you don't need to carry bundles of currency to the shop to buy a water bottle.

The analogy of the water bottle is known as hyperinflation, i.e. extreme inflation, which has happened in the past with Weimar Germany in 1920s, Venezuela and Argentina recently and many more African countries. Even US had a high inflation period in the 1970s, though it wasn't hyperinflation, US had 20% inflation at one point which caused public panic and devaluation of US Dollar. Inflation is a psychological phenomenon where fear of scarcity causes you to pay more for an item. This fear spirals into an escalating crisis that causes your money to become worthless.

But why does currency get devalued? There are multiple reasons including poor economic policies of the Govt/Central Banks, scarcity of resources(poor supply), high demand, crop failures, natural disasters and war. These increases the cost of items that you buy, which makes the value of currency to depreciate. So, you need Gold in your portfolio to counter these risks, to be able to buy goods using Gold if your Dollars/Rupees/Euros etc become worthless. That raises another important question, how do you accumulate Gold in your portfolio? For hedging purposes, you need to keep Gold such that you can access it easily and utilise it for buying stuff. So, it needs to be liquid, meaning easy for you to transact. Physical Gold and ETFs provide good liquidity to use them as alternative to money. Whereas SGB isn't liquid and hence is not suitable as a hedge. Though you can sell SGB on secondary market, the price spread is too large and you might not be able to get the full value while selling SGB. And commonly, we are advised to have 10% of our portfolio allocated to Gold, but my personal approach would be to have a dynamic asset allocation for Gold based on the prevailing economic situation. The 10% number cannot be a fixed allocation, you need to increase the allocation if the risks of currency devaluation are more at any point in time. That way your portfolio and purchasing power does not diminish during a financial crisis. You can, ofcourse fall back to 10% allocation as and when risks abate.

So the thumb rule is,

  • Sovereign Gold Bonds (SGB) can be invested when you need to buy physical Gold or jewelry for the future and not for hedging purpose. By investing on the bond, Gold price is tracked and you don't end up with a shortfall in money at the time of jewelry purchase.

  • Physical Gold is the best option for hedging for hyper-inflationary events since you have ready availability during a deteriorating financial conditions.

  • ETFs provide an easy means to trade and sell Gold immediately for raising Cash for emergency. ETFs also help for hedging though you are dependent on Govt regulations and banking system which may or may not work during a financial crisis. Same goes for Gold MFs.

Now that, you are now clear about what purpose Gold serve in a portfolio, you can either choose to stop reading further or if you need more understanding of the historical events related to Gold and how the current macro environment warrants for having a decent allocation to Gold, please read on further.

The general definition that Gold is a hedge against inflation is partially incorrect. By saying a hedge, we are indicating that it is directly correlated, meaning if inflation increases, Gold prices increases and vice-versa. But this definition has changed since year 2000. Prior to 2000, Gold price was indeed directly correlated with Inflation. This was because pre-2000 global economy was in an inflationary regime and with lot of headwinds. Below chart explains how rising inflation caused Gold prices to increase and falling inflation caused Gold prices to fall pre-2000.


After 2000, Gold was no longer directly correlated to Inflation, but it was correlated with the Currency (Dollar). So instead of being an inflation-hedge, Gold became a currency-hedge. The 2 charts below establish this observation very clearly.


The third chart is highly significant. The correlation with Dollar is quite evident, specially since 2020. Until August 2020, Dollar got devalued due to excessive Quantitative Easing (Colloquially known as Money Printing) by US Fed. But as inflation went out of control, Fed starting rising rate and reduced it's balance sheet( Quantitative Tightening a.k.a, withdrawal of availability of money a.k.a Dollar appreciation). This cause Gold prices to initially drop and then increase later as Dollar depreciated slightly in 2023. Effectively Gold remained flat on a YoY basis between 2020 & 2023, while inflation was raging. Clearly the notion inflation-hedge is weakened, instead truth is, it was a currency-hedge. Suppose a hyper-inflationary event does occur causing both inflation to spike and dollar getting devalued heavily, Gold will appreciate exponentially as a counter to currency devaluation, thereby becoming an inflation-hedge. So it is right to say that Gold becomes an inflation hedge only during hyper-inflationary events and not in the initial phases of historically high inflation which has been the case since 2020.

There are reasons why things changed in 2000 with respect to Gold prices. Central banks such as Fed, ECB, RBI etc hold Gold in its reserves. Prior to 2000, the central banks started selling Gold in the reserves heavily and accumulated the Dollar instead, since that was a period of globalization. In 2000, an agreement was signed that prevented central banks to sell Gold from their reserves without any control. The Washington Agreement was signed such that central banks cannot sell more than 400 tonnes of Gold annually. This put a backstop on the Gold prices. In addition to that, most of the easy Gold was mined out of the ground already, about 85% of the known mining reserves. So it became more and more difficult to find new Gold ores, mine them and get them into the market. This scarcity naturally made Gold prices appreciate. This finite nature of Gold will get more prominent as current Gold mines get empty in future, hence prices stay elevated.

But after 2020, due to US trade war with China and the Russia-Ukraine wars and subsequent trade bans, the global economy has entered into an era of de-globalization. The BRICS countries are trying to de-dollarize and remove Dollar as the global reserve currency. By default, this is beneficial to Gold as an alternative asset. In-fact, central banks around the word has shunned the selling of Gold from their reserves and instead, accumulating Gold at a rapid pace unseen since the start of the century. This shift in central banking policy itself is a positive for Gold.

All that said, the global economy seems to have entered an era of higher inflation due to trade-wars, de-globalization, reckless QE and Sovereign debt levels. US is sitting with a 130% debt to GDP ratio, highest in its history. Considering the past monetary policies of the US's Fed & Europe's ECB and its inability to reduce its balance sheet and debt without blowing up the global economy, QE 5 (So far 4 QEs have been done this century) cannot be ruled out. Another QE is certain to devalue the Dollar thereby triggering a significant inflationary response. The risks of higher inflation has increased in the macro-economic environment that warrants for an increased allocation to Gold to help us retain our purchasing power. For technical analysis of Gold price, please refer my previous article "A Case For Gold", written June 2021. That makes for a strong case to consider Gold as a hedge in your portfolio allocation.

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