All that glitters is not so golden

Gold is grabbing headlines almost every day. We Indians have been accumulating gold for generations by way of jewellery and hold the largest quantity in the world. Official estimates put Indian gold holding at more than 18,000 tonnes, worth a trillion dollars. Unofficial estimates peg the holding far higher.

Gold has outperformed the Sensex for nine years. Obviously, all investors must be rejoicing and more and more are turning towards the yellow metal. In the first four months of this financial year, India has imported as much gold as oil. The amount of savings being invested in gold is huge and may have severe ramifications for Indians and gold prices in the world.

Let me present the dark side of investing in gold. Many people believe gold is a safe investment avenue. But, it has given a negative return for a long period of time in the past. The price of gold in January 1980 was about $835 per ounce and this level was not again breached for 27 years till December 2007. This lean period for gold laid the foundation for the bull run in the metal price in the last couple of years (see table).

Gold gave good returns between 2000 and 2010 as it did not return enough between 1980 and 2000. If gold returned handsomely between 2000 and 2010, is it fair to expect between 2010 and 2020 a similar trend or the law of averages to catch up with the great bull run? Notwithstanding all the bullish argument about gold, history does indicate that gold returns can moderate in the coming decade on the back of stupendous performance in the past decade.

Many people believe that gold has outperformed equity. They can't be more wrong. The sensex has delivered about 10 times more than gold in 31 years (between January 1980 and June 2011) in rupee terms. If we exclude the rupee depreciation, the Sensex has delivered 81 times more than gold in the same period. In effect, rupee depreciation from below Rs 8 to one dollar in 1979 to Rs 46 to one dollar in 2011 has given bulk returns to Indian gold investors in 31 years. In today's scenario, where many people expect the rupee to appreciate in future, a significant portion of gold's past performance can disappoint investors.

Many people believe gold is ready cash. It can be sold at any point to convert into cash. Under the RBI's regulations, banks cannot buy gold. Liquidity on gold is provided by jewellers and commodity exchanges. God forbid, if Indians decide to sell one per cent of their gold holding due to high prices, it will require more than Rs 44,000 crore of liquidity from jewellers. I doubt if such liquidity will be available without cost. Gold is probably liquid because few people want to sell it.

The point I want to highlight is that all that glitter about gold is not so golden after all. Gold has a cycle. It has given negative returns in the past and it can give negative returns in the future. Gold has underperformed equity in India over a longer period of time. Fundamentally, that is not a surprise, as gold has an inherent value and is expected to perform in line with inflation, whereas equity is theoretically supposed to outperform inflation. Gold is illiquid, especially in India, as there is no institutional mechanism to buy it.

While investing in gold, an investor should consider the above mentioned dark sides. Do consider this quote of Warren Buffet: "When someone is buying gold, he is betting on someone else finding it more attractive in the future. That is, investing in the price of an asset versus investing in the productivity of the asset."

In some sense, if we accumulate all of the world's gold, it will probably fill one big room and cost you about $10 trillion. That amount is equal to 7.5 times India's entire market capitalisation. With that equation, it makes sense to invest in India's entrepreneurs with a golden touch, rather than yellow metal.

(Data from Bloomberg and the author's calculation) The author is president, corporate banking, Axis Bank