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Asset Allocation: Gold and Silver as an Investment Class

Let's talk about gold and silver as an investment class and how does it fit in one's portfolio. The objective of writing this post is to understand whether gold & silver is more of an asset or a currency, whether it is suitable for risk diversification or return maximisation purposes, how has gold performed historically and what all an investor needs to be wary of before investing into the yellow and silver metal.

Note: I have used gold for analysis, silver behaves like gold most of the times in terms of its properties and returns, with gold being less volatile than silver. I have also mostly used USD prices instead of INR, as there was insufficient data available on INR prices.

Let us first understand the basics of this hard commodity and start with why it is even considered as an investment class in the first place. What does gold/silver derive its value from?

The most basic premise is that gold/silver serve as excellent store of value which means that it maintain its value without depreciating. It is said that gold is the best form of currency known till date. Unlike other form of currencies used in history like cattle, which decays in few years, gold and silver maintain their purchasing power throughout multiple years and do not depreciate. If you are wondering about our current currency i.e. fiat, it is no different than a cattle. Let us test this claim and compare fiat currency and gold.


Fiat Currency vs Gold

Fiat Currency like USD or INR is said to serve as store of value as they can be exchanged for something valuable even after number of years. The issue is that inflation would eat away a lot of its purchasing power in those years. Here's a chart showing how $ lost its value to inflation over the years -

Source: Fred

The above chart shows that $1 value in 1913 has now depreciated to $0.038 in 2020 (mainly due to inflation). However, fall in purchasing power of $ is now slowing down because as countries moved to developed stage, they tend to experience low inflation and interest rates which reduce the fall of currency value -

Source: Author's Calculations

Gold, on the other hand has been able to maintain its inflation-adjusted value quite well all these years -

Source: MacroTrends (the above are for gold per ounce)

It shows that gold is a much better store of value than a fiat currency. Think about it, what kind of currency it is which cannot hold its purchasing power throughout years? I recently read the below line somewhere which goes -

Our Government calls this ‘inflation', when in reality it's devaluation.

The reason why gold has stood the test of time is because of its limited supply.

Fiat currency on one hand has unlimited supply and can be printed on the will of the government, thus decreasing it's purchasing power (USD and INR both are not gold-backed i.e. fiat). Gold on the other hand, has a limited supply with limited annual production (from mining) growth rate. It cannot be increased by more than a few % points.

Let us discuss this issue further.


Gold Demand vs Supply

As mentioned, gold supply is mainly limited to the amount of gold being extracted from mining which itself cannot be greatly increased due to cost and technological constraints. Technically speaking, gold supply can be deemed as unlimited as it can be CREATED by nuclear reaction of few elements but its costs greatly out-weight its current market value thus one cannot make money through this process. But first, how much gold is left to be mined in the world?

  • Estimating total gold left to be mined in the world

It is a rather complex question to answer. Mining companies take an estimate of the volume of gold than remains in the ground in two ways:

  1. Reserves - gold that is economic to mine at the current gold price.

  2. Resources - undiscovered gold or one that will potentially become economic to mine after further investigation, or at a higher price level.

The current 2020 estimations for the below-ground gold are about 50,000 tonnes of gold reserves left to be mined. Around 190,000~ tonnes of gold has already been mined in total (estimates vary 20%~ for different agencies).

Gold resources can be tapped in the future with the discovery of better technology and mining capabilities which makes gold mining feasible. Gold resources will also become available once current gold prices reach a level where the prices out-weight mining costs thus incentivising miners to extract gold.

  • Demand and Supply

Supply -> Gold Production Growth Rates (in metric tonnes)

Global gold production is expected to grow around 2.5% yearly from 2020 to 2029 according to Fitch Solutions.

Demand -> Looking at the demand side of gold, we see interesting observations:


(NOTE: These are H1 numbers and not annual numbers)

While demand from Central banks and investment flows has been steadily increasing from the past 20 years, the real usage of gold as Jewellery and in Technology (electronics, dentistry etc.) has seen stagnation or a decline. It makes sense because as gold prices increase, it makes it less desirable to buy gold for jewellery and technology purposes.

To observe a clearer picture, see below:

Source: Author's calculations

Real use = Jewellery + Technology demand

Total Inv. = Investments + Central Bank net purchases

Correlation between real use demand and gold prices from 2000 to 2020 is -0.66 whereas it is 0.94 between total investments and gold prices for the same period.

-> Governments, institutions, retail investors and general public have been increasingly buying and hoarding gold. This is actually one of the biggest drivers of gold prices upward as gold liquidity dries up. As more and more people start to accept and hold gold in their portfolios, it will create upward pressure on gold prices until it reaches a point where almost everybody owns gold just like currency. Think of it in this way -

You have 100 units of currency in a world with 1000 people. Currency itself cannot be valued because it doesn't have real value of its own. It is people's belief in it that gives it value. Once people start buying that limited currency, it will increase in price up to that point where almost all 1000 people can easily access that currency in a stable manner (that is what is actually happening with cryptocurrency right now, let us keep that for discussion for some other time).

It is worth mentioning here that gold doesn't corrode.

  • Relationship with Inflation

Due to the properties of gold discussed above, it is currently acting as a hedge against inflation i.e. the relationship between gold and inflation is positive. If Gold/$ = $500, inflation would decrease the value of currency (inflation is caused by printing money ONLY IF demand is there to support it. In cases with weak demand, money printing won't cause much inflation). Now as inflation decreases currency real value, gold should directly increase in value as the unit using which we were valuing gold at $500 earlier has now depreciated! Therefore, our expected return from gold is ATLEAST inflation rate.


Purpose of Buying Gold

Now let us come to the other part of the article which discusses about the purposes of investing into gold/silver as an asset class. I personally think this area is highly overlooked by most of the investors and is not given adequate thought while investing into hard commodities.

We can have either of two purposes due to which we might want to invest in gold -

(i) Risk diversification

(ii) Earning Alpha / Enhancing portfolio returns

  • Risk Diversification

In the first part, we established that gold works as an excellent hedge against fiat currencies and inflation. The way central banks have been printing currency out of thin air and constantly eroding the purchasing power of currencies (which by the way is one of the most important characteristics of money/currency) exposes us to the risk that we are living in a bubble which when propped can send the economy into a long depression.

Governments like US have been constantly increasing their debt levels to a point from where it's impossible to repay all of their debt. It is like debt and money printing has become the go to solution for central banks. Economists often use the ratio of Debt/GDP to compare debt levels worldwide. The issue is as governments take on more and more debt to increase GDP, the ratio might not seem to be increasing drastically as the numerator and denominator both increase.

Once any government defaults on their payments due to any reason (be it black-swan event or not) and GDP contracts, it will send its currency into a tailspin while gold prices will rocket. Covid-19 for example, has only led to a faster devaluation of currencies worldwide which is one of the few reasons gold has seen sharp price increases.

Buying gold considering it a safe haven and a hedge against currencies/economy will let you stop expecting real returns (returns above inflation) from gold and instead help you keep it as a long-term investment as a hedging tool. At the same time, it would preserve wealth by earning inflation level returns so that you maintain your purchasing power. We are buying gold as a true currency and risk diversifier here.

It is worth mentioning that it is very important to keep gold as a LONG-TERM bet for this kind of investor because of two reasons -

(a) The investor would not want to earn negative real returns in the short-term which are not in anyone's hands. The effect of negative real returns decreases as we increase holding period. If you face -50% return in 1 year, that would translate to -3.41% CAGR returns in 20 years.

(b) The sole reason we are buying gold here is for risk diversification purposes. No one can predict when the black-swan event will occur that will wipe out portfolio returns or collapse the currency or economy. It might happen 5 years from now, 50 years from now or never happen at all! Therefore, for this kind of investor, it makes sense to buy gold for permanent, long-term purposes.

  • Earning Alpha / Enhancing Portfolio Returns

The other reason due to which an investor would want to buy is to earn alpha through market timing and enhance portfolio overall returns. Here, an investor would expect to earn real returns through investing into gold. (NOTE: We are not talking about intra-day trade here, rather timing the entry to gain more than inflation rate in the long run, say more than 5 years)

For an asset class like gold, it is crucial to time the purchase as well as keep invested in it for a longer time frame to earn real returns. Let's look at the price chart of gold (per ounce) for once:

Gold earned almost no return for more than 2 decades (1980 - 2003) and then from 2011 - 2018. It was the bull run of 2003 - 2011 and the recent run up of 2019 till date which made all the impact. From the 40 year history of gold prices that we have here, we see 2-3 major price swings where gold has gained in value.

Source: Inflation rates from here. (the above are for gold per ounce)

When gold prices are compared with inflation-adjusted gold prices (since we expect atleast inflation rate return from gold), we see one could have earned real return (more than inflation) from gold if the person entered the position before gold touched $300~ (in 1980s, 2011 and well, 2020).

Note: This is not an investment advise, these are just my own observations on gold prices. With limited history of gold prices that we have, gold might move much beyond/below its current value. Please do your own research.

Let's see the impact of buying at different times in the history, holding them for atleast 5 years and selling them at 2020 for $600 would do to investment returns -

Source: Author's calculations

(How to read the above chart: If bought in 1972, inflation returns provided 3.9% CAGR whereas real returns provided 3.4% CAGR till 2020. If bought in 2001, inflation returns provided 2.01% CAGR while real returns provided 8.6% CAGR till 2020)

We see that inflation returns were providing the majority CAGR returns in 1970s and 1980s whereas buying in 1990s and 2000s (especially 2001) real returns dominated total CAGR returns. Year 2001 was the start of a new bull run for gold which ended in 2011-12 which is why one would have earned no real return if gold was bought in 2011-12 (similar to 1979-80).

One would have earned highest returns if bought in 2001 or 2015 (prior to start of bull run) but what are the chances that an investor can time his gold purchase so perfectly after all!

Here we are just trying to determine the importance of timing to earn real returns from gold. You see, gold did not earn any real return if bought in 1972 and sold in 2001. Moreover, gold would have provided no real return from 2011 to 2018. Therefore, an investor has to take this into account that gold has been seen not providing any returns from multiple years and hence it's important to hold it for longer time frames.

Let's take another scenario where gold was not hitting all time highs, rather it was stagnant at 2018 price of $400 in 2020 as well -

Source: Author's calculations

Now the picture changes completely. The investor can also face negative real returns from gold! An investor would have earned negative real return if gold was bought in 1979-80 and 2009-14. Not stretching it further, hope this would help in understanding the importance of timing the entry and investing for longer time frames in gold.

Wait, the process does not end here.


Portfolio Allocation and Other Considerations

Finally, we have to weigh in our own risk/return profile as well as decide the kind of return we would expect from gold/silver and then form optimal portfolio allocations. A 60 year old man would certainly have lower risk appetite than a 22 year old college graduate and therefore, might prefer higher allocation to gold in his portfolio. On the other hand, a 22 year old college graduate might prefer low allocation to gold as he might be targeting higher returns through other asset classes like equity.

Historically, gold has not been able to beat equity on average over the long term, say 10-15 years. Unlike equities, gold actually does not have any real underlying value which produces direct economic benefit. Investors have to weigh in opportunity cost of losing on higher returns from other asset classes in exchange for diversified portfolio risk.

It becomes a little more complicated for the Indian investors as they face additional risk of USDINR exchange rate movement. Appreciation of INR against USD results in negative return from exchange rate movement (although historically, INR has depreciated against USD providing far greater returns to Indian investor than US investors). Let's compare YoY returns of the 2 groups -

INR returns have almost always outperformed USD returns for the simple reason that INR has depreciated constantly against USD. In 1980, $1 = 7.75 INR and Gold = $180~ whereas in 2020 $1 = 73.5 INR and Gold = $600~. This means that INR depreciated roughly 10x while gold in dollar terms increased by 3.5x in 40 years.

As India moves to become a developed economy in the next 2-3 decades, we can make a fair assumption that the INR depreciation against USD is going to slow down in the coming 10-20 years. This would directly and significantly impact our returns. INR appreciation could even lead to negative returns which needs to be accounted for before investing into gold.

  • Back-Testing for Highest Portfolio Returns

Let us compare how gold has performed historically against indices like NIFTY 50 and what kind of impact it would have made if mixed with an investor's portfolio.

Gold actually usually moves opposite or uncorrelated to equities. Therefore, when equity prices shoot up, gold might move up/down or unchanged whereas when equity goes down, gold is usually seen going up (acts as safe haven). Comparing a simple GOLD + NIFTY portfolio with only NIFTY or only GOLD portfolio brings in good observations -

Portfolio 1 = 100% Gold

Portfolio 2 = 100% Nifty

Portfolio 3 = 50% Gold + 50% Nifty

Note: These 3 portfolios are constructed for comparison purposes and may not be the ideal portfolio allocations for an individual. Portfolio allocation and financial planning is a complex and highly customised process with unique set of allocation for every individual.

So when we put ₹ 100 to all three portfolios each, we see Portfolio 2 (i.e. all nifty) outperforms Portfolio 1 & 3 marginally by 26% (0.94% CAGR) and 12% (0.44% CAGR) respectively over a 25 year period. The portfolio ending values can be significantly impacted by changing the starting point of investment (1996 in this case).

The benefit of Portfolio 3 lies in lower volatility and risk diversification -

Source: Author's calculations

To make it simper to analyse, daily standard deviation of the three portfolios is -

Portfolio 1 -> 01.05%

Portfolio 2 -> 01.51%

Portfolio 3 -> 00.97%

It shows that Portfolio 3 has the highest volatility adjusted returns among the three. Having 50% gold in this case returned 12% less in 25 years (equals to 0.44% CAGR) with 33% lower daily volatility when compared to Portfolio 2. Now, we never rebalanced our Portfolio 3 in the above case which could have skewed the performance on one side. What if we rebalance the portfolio once every year?

  • The Power of Rebalancing

Now let us rebalance the portfolio once every year on the first day of January month. The Portfolio 3 performance significantly improves using rebalancing -

Source: Author's calculations

Portfolio 3 with 50% Nifty and 50% Gold outperforms Portfolio 1 & 2 by 52% and 20% respectively. The daily standard deviation reduces further from 00.97% to 00.90% as well. Of course, these are back-tested results and future performance can differ from past. We are just conducting this exercise to understand what impact can gold and yearly rebalancing make on our portfolio.

  • Why Gold has been able to deliver real returns

Statistically speaking, gold has been able to deliver quite good real returns for long time frames. Though gold does not possess any real value (apart from little real use case), it has still been able to deliver returns well over inflation rates. Gold, which is more like a superior and the only form of currency with limited supply would have been ideally expected to deliver only inflation returns so as to maintain its purchasing power (remember, it is just a currency). So why real returns?

As we discussed earlier, it is because money has now started flowing into gold like we saw earlier and people are more inclined towards holding gold as investment or a safe haven.

We are currently seeing investment demand including purchases from central banks strongly picking up for multiple years now (by the way, fiat currencies are also relatively new to the game with no more than 100 years of experience). Be it investors buying gold for return purposes or risk purposes, but it is clear that buyers are overpowering sellers and this trend might only strengthen in the coming years as global economies continue to get their currencies devalued and we might continue to witness real returns from gold as it gets added to global investor portfolios.


Conclusion: My View Point

It is important to know the purpose of investing in gold because an investor investing for hedging and risk management purposes would not be so worried for timing the entry, he would ideally buy gold for long-term with the view point that it would protect his portfolio against uncertain events. An investor entering for return maximisation purposes has to deal with timing the entry because with the limited history of gold and inflation rates that we have, it is rather unclear if gold will be able to deliver acceptable real returns and to what extent for extended periods. More so, the life of an investor and investment horizon is limited and has to be taken into consideration while entering the position.

Combining all that we have discussed till now, we can conclude that gold is a hedge against currencies, be it USD or INR and serves as a safe haven (at reasonable prices). If currency loses value, gold will gain since it doesn't lose its value (doesn't corrode) nor is its supply such that which can be increased dramatically at the will of the miners. The real use case demand is getting slow for a primary reason that gold is in fact getting expensive and consumer tastes and preferences are changing (although investment demand for gold is picking up steadily and has now overtaken real use demand!).

Personally, i can relate to gold as not an asset but a real currency which has much better characteristics than our fiat currencies. I would invest some proportion of my portfolio in gold for hedging and risk diversification purposes and also expect modest real return as gold prices increase with increasing acceptance and investment demand. If you are further interested in the topic of gold as a currency and demerits of fiat currencies and what they do to the natural working of the economy, i would highly recommend you to read more about Austrian economics.


Let us know if you found the article helpful by commenting below. We would love to hear your feedback. If you are further interested in valuation, do check out our Market Sentiment Tracker, our own index which reflects the greed/fear in the public and gives an idea of whether the market is trading at a premium or a discount.

Happy Investing!

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