In reality, is gold a good investment? Does it help in building our wealth? This post is to explain that in detail.
Forget what you know.
If we grow up believing in certain things, it is deeply engraved in our minds. We will not be able to let it go that easily. Most of the time, it works to our advantage and is for our good. But sometimes, it puts us in a disadvantageous position. This topic of gold is like that as well. So let’s forget what we know about gold for now. Let’s erase everything and start from a clean slate. That will help in understanding gold better.
Uses of Gold
Let’s begin with reviewing the use of gold. With the gold that is mined today, about 50% is used for making jewelry. 10% is used for industrial purposes. Because of its unique characteristics, we are using gold in electronics. That is the industrial usage we are referring to here. The rest, 40%, is used in investments. Like oil and gas, gold is also a commodity.
The price of all commodities changes depending on the supply and demand. If the oil supply goes down, its market will go up. That will lead to a rise in price. But for gold’s usage, its collection is well over the demand. They why its price keeps changing? That demand is coming from investment. Whenever we get into an economic crisis, investors will run towards gold. Why? Does gold deliver babies during a crisis time?
Not at all. Even during those crisis times, it just lays around the locker doing nothing. But during crisis times, everyone will be under fear. “What will happen to our country? What will happen to our currency?” That fear is what drives people to find a haven in gold. If we have gold, even if our currency loses its value, we can use the gold to exchange any goods, which is the rationale.
After seeing what happened in Zimbabwe and Venezuela, we can understand that rationale. Now let’s check out the historical return of gold. Gold is trading in the US dollar in the world market. So let’s check out how one ounce of gold has changed its value over time.
Depending on the period we are looking at, the return of the gold changes drastically. Gold was at a fixed price of $35/ounce since 1934. This $35/ounce continued for the next 37 years till 1971. In 71, then US president Nixon dropped the gold standard and freed gold price from being tied to the US dollar. After that, gold rose sharply to $850/ounce by 1980.
The annualized return for those ten years is around 31%. We can call that period the golden period of gold. For the next ten years, the price dropped to 400 something. The annualized return for that decade is -2.4%. The drop continued in the ’90s. In the following years, gold prices dropped from $400 to $280.
The annualized return for that decade is -3.3%. In the next decade, starting from 2000, gold came back from $280 to $1100. The annualized return for this decade is 14.3%. The annualized return for the next decade is 3.3%. Since 2020, the return for the last 1.5 years has been 10%. If we had stayed invested in gold for the past 40 years, our annualized return would have been 3.4%. This is in the US dollar – gold’s actual return.
But in the Indian rupee, the return for those 40 years is 8.5%. We already know the reason for that from our Asset Allocation episode. In these 40 years, the rupee has lost its value nine times from 8 Rs/$ to 74 Rs/$. So the return in Indian rupee looks bigger. But that extra 5% did not come from gold appreciation. But from Indian Rupee losing its value against the US dollar.
“So, can we but gold to beat the index? All experts suggest that gold could be a good inflation hedge.” but looking at the history of gold, it does not look that way. US inflation has risen on average by 4% per year from 1980 to 2000. If gold is an inflation hedge, its price should have gone up during that period. But in those 20 years, one ounce of gold has fallen from $850 to $280.
That means, for a strong currency like US Dollar, gold is not a reliable inflation hedge. Depending on the weakness of a coin in the world market, gold will be a strong inflation hedge for that currency. Do you think Indian Rupee will get weaker in the future? or stronger? Depending on that, you can decide on whether you can have gold as an inflation hedge.
Is gold a safe investment?
All that is OK. But gold is a safe investment. There is no reason to think twice about investing in gold. Is that right? How secure is gold? How do we measure the risk of an asset? We estimate that using its volatility. The measure of how far the price of an asset is moving up and down is volatility. The volatility of gold is higher than that of the stock market index.
If we look at the volatility of S&P500 since 1975, it is at 15%, whereas the volatility of gold is at 19%. If we ask whether the gold has given a higher return for that kind of volatility, the answer is No. In that period, S&P500’s annualized return was 12.3%, whereas the return of gold was 5%. So why would someone take a higher risk for an asset that gives a lower return? Good question.
Why are we investing in an asset? Because we are expecting a future cash flow from that asset. For bonds, interest, stocks, dividends, real estate, rent, etc. So for every purchase, we assign a price depending on its future cash flow potential and invest in them.
But for gold, there is no future cash flow. If we buy 1 ounce of gold for investment, it will be the same 1 ounce forever. “No, boss. You mentioned. We can make jewelry out of gold”. If jewelry is our need, we can buy gold. Nothing wrong with that. But the question here is whether gold is an investment. If investors come to know that the future cash flow of an asset is going to rise, they will be ready to buy that asset for a higher price.
That is how an asset appreciates its value. But as gold does not have any future cash flow, the only hope of the gold investors is that they can find another person to buy it for a higher price. In that regard, this is just like a bitcoin. But the surprising thing here is, gold supporters oppose Bitcoin. And Bitcoin supporters make fun of gold investors.
Who should buy gold?
Except for a few like Warren Buffet and Charlie Munger, few acknowledge that they are both equally bad as an investment. Does that mean that we should not be buying gold at all? No. Not at all. We can buy it. But buying it for investment is a questionable decision. So who should buy gold? If you like gold jewelry, then sure, you can buy it.
If you don’t believe in your country’s currency, you can buy it to minimize that risk. Other than these, knowing that during an economic crisis time, the stock market will go down. Gold in a portfolio will give a cushion to handle that blow. For that cushion, if you can let go off of some of your long-term growth – then you can buy gold as well. Also, folks who are trying to save gold for their daughter’s wedding can purchase gold.
But I would question why we should give our girl to someone who is demanding gold. But that is everyone’s personal choice. Finally, folks who are focused on building their wealth should not buy gold. As gold does not have the return potential for the risk we take, it is better to invest in an Index fund. This is my opinion. But for your happiness, you can have up to 10% of gold in your portfolio. Nothing wrong with that.
Sovereign Gold Bond
After all, this is personal finance. Make it unique, depending on your choices. If you have decided to buy gold, Sovereign Gold Bond is a good option. Remember I told you that gold does not have future cash flow? But this one gives 2.5% interest. As RBI issues it, it is a lot safer too. So if you are planning to buy gold for the long term, you can consider Sovereign Gold Bond.