Key takeaways
- It’s natural to feel tempted to buy an asset class when prices are shooting up
- But buying Gold or any asset because prices have recently shot up is not very wise because of the principle of “reversion to the mean”
- The asset class leader board gets shuffled randomly every year.
- There is almost no way to know which asset class will perform exceptionally well in the future
- However, asset allocation is one of the most important decisions. So the decision to have Gold or not is a crucial one
- Over periods of 20 years or more, equity has typically performed better than Gold but no one can predict whether that trend will continue or not
- Reason 1: Gold has proved that it cushions the blow of the stock markets when they are falling. However, the debt portion of your portfolio could serve this need as well.
- Gold prices have significant volatility although it’s volatility is lower than that of equity
- Gold & Equity price movements are negatively correlated
- Reason 2: According to Dr. William Bernstein, if one re-balances one’s portfolio regularly, Gold’s volatility helps generate 3% to 5% extra in returns over Gold’s baseline returns.
- Reason 3: Gold is also useful to have in times of geo-political or economic instability as also during periods of extreme inflation
- Gold does keep ahead of inflation most of the time, but then so does equity
Whenever an asset class like Gold or silver currently, or like small caps in the recent past, are having a meteoric rise in prices, it’s natural for us to feel tempted to add that asset class to our portfolio. In addition, we might even tend to feel a sense of regret at not having included that asset class in our portfolio earlier.
Beware the “Reversion to mean” principle
To start with, at times like these when Gold prices (or prices of any other asset class) are rising like crazy, one investing principle to always be aware of & recall is what is called “reversion to the mean” effect. It’s like the law of gravity – what goes up in price must come back down. So if Gold prices have been rocketing sky high of late, it’s likely (but not at all certain) the appreciation going forward will likely not be as meteoric or prices may even come down after a while based on the “reversion to the mean” principle.
See the data visualization below from Valueresearch. The leader board shows clearly that the leading asset class of any one year simply does not stay constant over many years. If you track any one asset class like Gold, you can see how it’s rank keeps changing from year to year. This is one angle from which the data is in a sense showing us the principle called “reversion to the mean” in action.
This is exactly why the gurus of investing tell us that adding an asset class / new type of investment category to your investment portfolio JUST because it’s recent returns have been stellar is not a good trigger or reason to invest in it.
Buffett observes that people who invest in an asset class whose prices have gone up sharply in recent times are like people driving by looking in the rear-view mirror.
Asset allocation: One of the most important investing decisions
It has been proved by multiple studies & research that your decision on what percentage of risky vs riskless (i.e. volatile vs non-volatile) assets you want to hold is indeed one of the most important determinants of long term investment returns. As we will see later in this article, Gold is certainly a volatile asset class. Therefore, deciding whether to include Gold and how much of it is clearly a very important decision.
This is why it’s good to step back a bit and get crystal clear about what the rationale should be for adding an asset class to our investment portfolio.
Long term returns of Gold as an asset class
Although the focus of this article isn’t the RETURNS one can get from investing in Gold, let us in any case look at the long-term returns of Gold as compared to other investment asset classes. This will hopefully help give us a “zoomed out” view of it’s performance rather than a more short sighted view of it’s performance.
Here are two visuals from Valueresearch that show the returns of Gold vs other asset classes.
As you can see from the above data, over longer periods like 20 to 45 years, stocks have outperformed Gold. So for the investor who has a very long term horizon of say more than 20 years, one could very well question the need for Gold. If the same trend continues in future, adding gold in such a case could arguably lower one’s returns over a 20 to 30 year period.
However, one can see that there are multiple 5-year periods where Gold leads. So it is certainly possible that in the future there will be significant & long periods of time where Gold will do better than Stocks and / or Real estate etc.
However, there is no way to be able to predict in advance in which decades Gold will perform better than other asset classes & vice versa. So the best we can do is to choose among a few asset classes that have historically beaten inflation, assess whether we can tolerate their level of risk and pick a mix of these asset classes.
Gold: Worthy of inclusion for 3 reasons apart from returns
That said, Gold is no doubt an asset class worthy of serious consideration in any investment portfolio. However, before jumping to invest in it, one should be clear about not only it’s long terms performance but also it’s volatility and what sort of conditions / environments favour Gold. One should also have some perspective on how each of these factors compares with other asset classes like stocks.
1. To cushion blows from the stock market
Gold seems to have a history of increasing in price or doing well when stocks / equity is performing poorly. So in a way, Gold helps cushion the blow from equity at times.
See the charts below from Valueresearch.
You can see from the above chart that during multiple periods when stocks were performing poorly, Gold did well. So Gold definitely helps cushion the blows of equity. This is what in finance / investment terminology, Gold has what is called a “negative correlation” with equity. i.e. when one of them is going down the other is going up and vice versa.
For the more technically / mathematically inclined, the graphics below show the correlation between Equity & Gold.
As you can see from the above, Gold’s correlation with equity is minus 0.46
So there is no doubt that when equity falls, Gold tends to go up and could cushion the blow. But then again, one could argue that that’s exactly what the bond / debt / FD portion of your portfolio is anyway meant to do as well.
2. Volatility pumping
Here’s a chart from freefincal that shows the standard deviation (i.e. volatility) of Gold compared to the Nifty 50 & debt.
As Pattu from freefincal points out, contrary to popular belief, Gold is quite a volatile & therefore technically risky asset class in the short term. Gold’s volatility, although lower, is in many ways comparable to that of equity.
However, Dr William Bernstein points out that having a volatile asset class in one’s portfolio can be an advantage that can be leveraged. Dr. William Bernstein, says that if one re-balances one’s portfolio regularly, Gold’s volatility helps generate 3% to 5% extra in returns over Gold’s baseline returns.
One could also consider value averaging instead of an SIP while buying Gold. This is because Value averaging is a technique that fundamentally looks to take advantage of volatility / asset price fluctuations.
3. During periods of extreme inflation, geo-political & economic uncertainty
Although the data on this is not conclusive, opinion is that at least In periods of extreme inflation, since a currency loses much of it’s value, Gold which is considered a “Real” / “hard” / “tangible” asset tends to do well.
As you can see from the above chart by Arthgyaan, for the most part, (though not always) Gold has indeed provided inflation beating returns. But then again, so do stocks / equity most of the time.
Gold also has the reputation of being a safe haven of some sort. So any sort of crisis or uncertainty of a geo-political nature seems to trigger buying of gold by large financial institutions & therefore an increase in prices at such times.
If the current times with Trump’s trade tariffs and the incredible uncertainty that comes with that, wars in Gaza & Ukraine etc. are anything to go by, these are certainly times of uncertainty and it’s no wonder Gold has been rocketing upwards.
Summary
Although Gold has provided stellar & unprecedented returns in the recent past, long term historical data for periods stretching from 20 to 45 years seem to suggest that Equity / stocks still do perform better than Gold. So if we go purely by historical data, for periods of 20 years or longer, adding Gold might actually reduce your returns. But, of course, as always, no one can predict whether that trend of outperformance of stocks will continue in the future.
If the “reversion to mean” principle of finance is to be believed, when any asset’s prices have risen sharply in the recent past, there is a strong tendency or likelihood that prices will be muted relative to other asset classes going forward or decline.
The data seems to show that when equity falls / underperforms, Gold does well. So Gold does indeed cushion the blow of equities when they’re doing poorly. But then that’s what most people have debt / FDs in their portfolio for anyway.
The volatility of Gold provides an opportunity to generate 3 to 5% higher returns via regular & disciplined re-balancing with other negatively correlated volatile asset classes like Equity.
Lastly, there seems to be a wide spread tendency for financial institutions & people in general to flee to Gold in times of economic or geo-political uncertainty. So at such times it’s likely that Gold prices will rise dramatically.
If you’d like a free spreadsheet template for value averaging to take advantage of the volatility of Gold, email me on mezjan@investmentcoach.co.in and I’ll be happy to send it across.
Disclaimer: I am not a financial advisor. My articles are meant for people who are not savvy or well versed with personal finance and investing and find it difficult to grasp all the jargon typically used when discussing such topics. I hope to be able to demystify investing and make it as simple as possible for everyone. I’ve invested in Mutual funds for approx. 24 years. I’ve also been a diligent student of the subject of investing over the past 24 years learning & applying the writings of luminaries in the field. In these articles I’m merely sharing my experience & learning from that investing journey and the books of luminaries in the field in the hope that it might help others in some way. I am in no way directly or indirectly claiming to be a hot shot investor who has generated exceptional or even above average returns during my investment journey. However, I am quite confident that even if all you do is learn from my mistakes, educate yourself on sound investment principles & develop good financial habits you will benefit greatly. Please ensure that you consult a financial advisor before taking any decisions or actions concerning your personal finances or investments. I shall not be liable.