How much to invest in gold ?

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Let your motivation dictate the share of the yellow metal in your portfolio

Enough has been said and written about gold as an investment option. The latest argument is that the craze for gold among Indian households is endangering our country's balance of payments. The policymakers are busy trying to find ways of discouraging investment in gold, but if households keep the common good in mind, they would be paying the market price for gas cylinders as they do for, say, their mobile phone bills. After all, private decisions are driven by private motives. So, how should a household look at gold from its own perspective?

Gold is primarily acquired for its merit as a store of value. Even if the worst crisis hits a family, the gold that it holds could be put to use anywhere in the world. In fact, this attribute and rationale encouraged the traditional wisdom of adding gold ornaments to a daughter's wedding trousseau. Every family needs this buffer, but one should desist from overdoing it. Gold is a safety net and this is the role it plays in one's investment portfolio too. This need could be met by a 10% allocation to gold in a family's portfolio.

There are two other drivers of investment in gold. The first is the need to hoard undisclosed cash earning. The other is to use gold as collateral to borrow money. Both these uses have been entrenched in the system due to flaws that have persisted for a long time. The lack of law enforcement when it comes to income disclosure and tax collection has led to large-scale hoarding of illegal income in the form of gold. The purchase of gold to hoard wealth neither requires know-your-customer (KYC) compliance, nor is it declared as wealth.
Gold is also seen as a source of liquidity, prompted by the lack of widespread banking, investing and insurance facilities, and the non-inclusion of many households in the financial markets. It is not uncommon for those with irregular and seasonal incomes, be it agricultural labour or urban casual labour, to save periodically in gold. This is pledged to generate cash during lean times and recovered when incomes go up. Unfortunately, this practice has also spread among those with access to banking facilities. The ease of transacting, ability to transact in cash, and less stringent processes have led to a sharp growth in the market for loan against gold. We have now triggered an auto-demand cycle, where more gold is bought on whim and then used to raise money as needed.

If specific motivations drive a household's purchase of gold, higher allocation comes from its balance sheet. In one case, the skew is due to illegal cash; in another, the skew comes from lack of stable income. For all other households, allocating too much to gold can be harmful for long-term wealth.

There are two prime motivations that are fuelling the demand for gold. The first is the attraction to a physical asset that creates a sense of well-being. Then there is the bias from the recent outperformance of gold as an asset-it has beaten equity, property and bonds by a large margin in the past five years.

Hoarding gold is a clear case of acquiring an asset for emotional rather than financial needs. Such investors should realise that gold generates no income while idling; it has to be sold to redeem the economic benefit. The household must have a firm plan to sell the gold as and when needed since that is the main purpose of building assets. From the point of view of the latter, pure gold bars and coins are superior to jewellery. The bottom line? It would be a folly to purchase gold jewellery and assume you've made a smart investment. Yes, there is snob value, but little else since both are accessories, not investments.

Those who have bought gold swayed by the sharp rise in prices in the recent past have made a tactical asset allocation decision. In the market place, different assets do well at different points of time. So, instead of blindly jumping on the bandwagon, investors need to focus on the reasons that might have caused gold to outperform equity and other assets, and whether those conditions can be expected to prevail in the future. The period after the 2008 global economic crisis was filled with uncertainty-large investment banks failed, countries defaulted, currencies tumbled and businesses folded. Heightened
uncertainty makes gold a safer investment and leads to it being given excess weightage in a portfolio. This, in turn, pushes up its price.

The big question now is whether the global uncertainty will continue. Is there new information about new risks in the global market? If the answer is no, over-allocation to gold may be a harmful investment strategy. The trouble in a bullish market for any asset is that the behaviour of prices clouds everything else. The overconfidence is evident when most investors discount any new negative information and focus only on the positive. Those who have ignored the correction in gold prices in the past three months may be doing just that.

If you are considering investing in gold, start with questioning your motivation. Are you trying to evade tax? Or is asset allocation your main agenda? Your answer will dictate how much wealth should be stashed away in gold. Be sure you have a strong reason to increase its share beyond the basic 10% of your wealth.

 

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