Gold and its Glitter: Role of Gold in Portfolio Asset Allocation

“You can fondle it, you can polish it, you can stare at it. But it isn’t going to do anything.”

That’s what Warren Buffett had to say about gold. Essentially it is a useless commodity. But it has gone up every year for the last 10 years. It has given returns that are, perhaps, better than almost all asset classes over the last decade, including stocks and real estate.

goldimagesFor investors like Buffett, having gold in their portfolio may not make sense, but for an individual investor, it might make some sense to have a part of his money in gold. The reasons are not far to see.

As an asset class, gold is a funny asset which is difficult to understand and value. It has no inherent value as such. Neither does it produce anything useful, nor does it go as input into producing anything useful in a meaningful way.

Gold is different from other metals or commodities. To some extent, commodities and metals have material value as inputs to something, and their prices can vary based on supply and demand cycles. You may not like the extent to which they may fluctuate, but at least there is some basis on which someone can say that it does not make sense to pay so much for a particular commodity, or that it is cheap at a particular price.

Gold is also different from stocks – which are productive business activities and have the potential to give you both dividends and capital gains if selected well. There are multiple ways in which you may value stocks or companies, but there is a clear economic rationale for each of these. Opinions may never reach a common point, due to which you have markets and all the related volatility, but at least one can have an opinion based on a method of valuing stocks or businesses on their own.

Gold is different from real estate too – in the sense that one can broadly estimate the cost of constructing a property including land and material prices as the base minimum value,  a potential rental income based on economic conditions as the minimum rate of income return, and add capital gains which are broadly in line with inflation as the long-term returns from real estate. It is possible to, at least, broadly value it.

It is even possible to value currencies – based on the country’s macro-economic situation and speculation on what might happen.

goldeggimagesBut Gold? How does one value it? It is just there. One can calculate the cost of mining it as the base – but it is far too low, and not increasing at the rate at which gold prices are. Gold has historically been a hedge against almost everything. Most of the time it is useless as a productive asset. It may at best match inflation, thereby growing at a rate at which currency falls. But in times of crisis, it tends to become a currency of its own. Specially when people want to sell all their stock and run (not exactly that – but are jittery in general), are not confident of real estate prices going up due to some reason, and also do not believe in the value of currencies due to huge economic problems, the thing they seem to rely the most on is Gold. For some reason, some of these fears have been around in the global economy for the past few years, and perhaps will stay on for a few more. So Gold has risen, and may keep doing so – till those conditions continue.

Individual investors should still have stocks, real estate and cash/fixed income as core to their assets. But have a bit of gold too – anywhere from 5% to 20% based on your preference. A chaotic environment favors gold, and if it subsides, you anyway have the other assets. Gold will help provide some stability when others are unstable. Purely as an insurance and for diversification, there is still some truth in grandma’s advice to buy some gold.

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