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Why Gold As An Investment Is No Choice?

While Defenders Of Yellow Metal Suggest Investors To Have Gold In Their Investment Portfolios, We Believe That Considering Gold As An Investment Is Unintelligent.

The centuries-old battle of Gold Vs Equity remains seemingly unabated. Where defenders of the yellow metal admire it for its inherent value, use as a hedge against inflation and portfolio diversifying ability, we hate gold for its non-utility and unproductiveness.  In fact, we believe that gold is not an investment at all. And the very premise of such an argument lies in the concept of ‘investing’.

So, before we go any further, let’s first seek to understand the term ‘investment’.

What Is Investment?

Investment simply means buying something and confiding in its earning ability in a way that one can justify its future earnings against the sum of money invested today. It does not mean buying something and selling it at a higher price. That’s speculation! The terms investment and speculation are sometimes used interchangeably, but in reality are two different things. It is rather unjust to use one in place of the other. To further supplement the concept of investing, let us look back at the explanation given by sage of Omaha, Warren Buffett, in 2011 letter to Berkshire shareholders.

“Investing is often described as the process of laying out money now in the expectation of receiving more money in the future. At Berkshire we take a more demanding approach, defining investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power – after taxes have been paid on nominal gains – in the future. More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date”.

Furthermore, when we say investment involves certainty to deliver increased cash flows over its holding period, we implicitly mean to say that there is some risk attached to it. If an asset promises higher future returns, such an investment involves higher risk. On the other hand, if it promises secured future returns, it involves lower risk.

So the question arises, what is risk in case of investments? Risk of an investment pertains to its odds of losing future cash flows over a given holding period and not its volatility. No doubt the underlying asset is exposed to price fluctuation; such volatility should not be taken as risk so long as the asset is certain to deliver increased earning capacity over the given holding period.

Hence, as an investor your focus should be on the earning capability of the underlying asset over its holding period rather than volatility risk involved or its price fluctuation.

Now, with complete background on the concept of investment, let’s explore the investment choices that Warren Buffett once discussed with his shareholders. He simply laid down the characteristics of each of the investment categories to emphasize how stocks appear to be superior investment choice over all the other asset classes.

Types of Investment Choices

Majorly there are three types of investments:

  1. Low Risk or Currency Based Investments
  2. Investment In Non – Productive Assets
  3. Investment In Productive Assets or High Risk Investments

Low Risk or Currency Based Investments 

If you’ve been investing in treasury securities, bank deposits and money market funds, you’ve been doing so to earn regular returns and undertake low risk – the two key characteristics that make such investment options relatively safe. But the naked truth is, they are not safe at all! Why? Dwindling economic scenario over the years has been forcing governments world over to introduce policies that have been creating inflationary conditions. This in turn has been destroying the purchasing power of currencies, thus wiping out returns on your low risk investments.

And if you have been a tax paying investor, it has been adding to your pain all the more by further depleting your returns. Though, the inflation related risk can be met by governments increasing the interest rates, but again these should be high enough to compensate for such a risk.

Investments in Non – Productive Assets

The second category of investments relate to non productive assets – those that do not produce anything (like regular returns on assets such as treasuries), but are likely to increase in value based on the buyer expectation that a pool of other buyers would be willing to pay more for them in future. The perfect example of a non – productive asset is Gold.

So, when it comes to the supporters of gold, they fear all the other assets, especially fiat paper currencies. They assert that fiat paper currencies are backed by governments instead of any physical commodity and are depreciating in nature, thus inducing them to fall for gold. Further, they believe that this fear will motivate other pool of buyers as well to invest in gold – a fact that has been a reality in recent years. Besides this fear, the rising prices of yellow metal have attracted investors all the more. 

Though gold has been a favorite asset class among investors for the reasons mentioned above, it has two critical short comings. First, Gold Is Unproductive as it does not generate any cash flows. This means that the asset does not promise any future earnings or right to payment at a later date. Hence, with reference to the gold’s unproductive attribute, we would want to put it the way Warren Buffett demonstrated in one of the interviews –

“I have no views as to where gold will be, but the one thing I can tell you is it won’t do anything between now and then except look at you. Whereas, you know, Coca-Cola (NYSE:KO) will be making money, and I think Wells Fargo (NYSE:WFC) will be making a lot of money and there will be a lot — and it’s a lot — it’s a lot better to have a goose that keeps laying eggs than a goose that just sits there and eats insurance and storage and a few things like that.”

Second, Gold Has Little Industrial Use, thus making its utility value zero. Now, when we say that gold is valuable, what do we mean by it? To understand this, it is first important for us to know the meaning of value. Value can be broken down into two parts: ‘Use Value’ and ‘Perceived Value’.

Use Value refers to how useful the underlying object is. This can be understood by undertaking a simple test. Imagine if the government bans the sale and purchase of gold from now, would gold still be valuable? No, as there would be no buyers and sellers for the yellow metal in the market. However, if we were to take steel instead of gold in this test, for instance, banning steel would mean the collapse of the civilization itself.

This is because steel stands as one of the most commonly used metals in the world across a vast expanse of industries including automotive, medical, architecture and construction, energy and food and catering. Therefoore, it’s quite reasonable to conclude that steel has a ‘Use Value’ while gold has none.

Perceived Value, on the other hand, is more abstract measurement that represents the price consumers are willing to pay for the underlying asset, gold in our case. In India, gold is synonymous with social status and wealth. Therefore, gold jewelry makes for a major portion of annual gold demand in India.

But such a pleasure causes a serious damage to the economy as a whole, which is that we, as a country, import the largest quantity of the yellow metal in the world. As a consequence most of the country’s wealth is locked in a dead asset (one that doesn’t put money into your pocket regularly). Had this amount been invested into productive assets such as stocks, India wouldn’t have to ask for foreign investments to the scale it is doing now.

Since a handful of retail investors (like you and me) invest in securities, it leaves the government with no choice but to make huge borrowings from countries such as China, Russia, and Japan. As a result, these countries reap the benefit of returns. Therefore, gold’s usage value being none, it has a perceived value which is derived from its rarity and robust demand, especially from the emerging world.

Owing to these inherent shortcomings, it is a bad idea to invest in yellow metal. In fact Warren Buffet explained why is it so in his 2011 Letter To Berkshire Shareholders. He upheld that if we take the whole of the world’s gold and meld it together, it would form a cube of about 68 feet per side. He took the value of this cube to be $9.6 trillion and called this cube to be pile A. He then asked to assume a pile B of an equal amount constituting 400 million acres of US cropland, 16 Exxon Mobils and remaining cash of $1 trillion.

He therefore concluded that this cube of gold would remain unchanged in size and not produce anything a century from the year 2011. However, 400 million acres of US cropland would continue to generate the produce in abundance, 16 Exxon Mobils would distribute trillion dollar dividends and would probably invest trillions in its assets. Though panic might attract investors towards gold, Buffett held that $9.6 trillion valuation of pile A would certainly compound at a rate far inferior to that achieved by pile B. 

Investments In Productive Assets or High Risk Investments

Finally the third category includes productive assets that have the ability to generate cash flows over its holding period. Take for example stocks. Stocks have the ability to produce dividends and serve the very purpose of generating cash flows in future. What we mean to say is that when you invest in businesses, companies get funds to expand its operations and hence generate profits.

Another good example of productive asset is farmland. Land can be used to cultivate crops and generate produce that can be sold at the year end. Similarly, house is another productive asset as it can be leased to generate rental income over the holding period. Moreover, one can also sell the underlying property to earn capital gains.

Needless to say, Warren Buffett too is a fan of investment in productive assets. He believes that these assets should be capable to generate returns even during inflationary situations. He further states that even if such investments do not give returns to compensate for inflation risk, one is still better off by investing in stocks over gold or currency based assets.

Why Gold Is Not An Investment?

With clear understanding of investment as a concept in the backdrop, let’s try to get the point in our argument above that says “gold is not an investment at all”.

Considering the definition of investment, its quite apparent that gold is not an investment option at all. Rather, it just acts as a great hedge against economic shocks. Investment as a concept means forgoing consumption now in order to have the ability to consume more at a later date. Keeping this in the backdrop, considering gold as an investment choice would not be justified as it is non-productive and does not generate returns like stock dividends or bond yields over its holding period.

Now the question arises, why do people invest in gold? People invest in gold because they lose faith in other asset classes as a result of market down turn due to any state of emergency, economic or political turmoil. During such market conditions, demand for gold rises, thus increasing its price and giving returns to the investors. 

This price fluctuation in the yellow metal is what makes investors consider it as a lucrative investment option. However, one should not forget that such phases are short lived and give annualized returns which are immensely low. This is so  because once the market conditions improve, gold loses its charm, making investors move towards relatively risky investments such as stocks and bonds to earn extra returns.

Therefore, instead of focusing on comparing gold prices at different points in time, investors should focus on annualized returns generated over its holding period. So if you are a long term investor, gold should certainly not be an investment choice as it does not give you attractive returns over the long period. 

Why Stocks Beat Gold In The Long Run?

Foreign Exchange is yet another aspect of buying gold that often bypasses our view when considering gold as an investment. We can guarantee these figures will shatter the illusion you had about gold until now:

1980

2015

CAGR*

GOLD (Price/oz)   $

$ 820

$ 1117

0.88%

GOLD (Price/oz)   INR

INR 5000

INR 71488

7.89%

SENSEX

100

28020

17.47%

CAGR*: Is the Compounded annual Growth rate, or the rate by which you money or investment grows on yearly basis. Note that it is different from Simple Interest in that rate is calculated on the same principal amount year after, while in Compound interest rate is calculated on Principal + interest for previous year.

Something unusual is happening here. In $ terms, the price/oz went from $820 to $1,117 in 35 years. But surprisingly, in INR terms it jumped from INR 5000 to INR 71,488. Why there exists such a striking difference? In 1980, 1$ = INR 10 but by 2015 $1 = INR 64. Meaning that the big jump in prices of gold that we’ve seen in the past is because the $ became 6.4 times stronger in the past 35 years or because INR has become weaker by 6.4 times.

What this simply means is that we can buy less for an INR  today than we could’ve 35 years ago. Remember how your grandmother always said ‘Oh we used to buy a kilo of rice for INR 5 in our time’. So this brings us to the uncomfortable truth that gold isn’t an investment at all! In fact, it’s so bad that you could’ve earned 17 times your money just by keeping it in bank itself and a whopping 24 times if invested in stock market.

Moreover, while gold rose by just 0.88% between 1980 to 2015, money in Bank and Sensex rose by 10% (approx.) and 17.47% annually, respectively. Therefore a sum of INR 10,000 invested in gold at a CAGR of 0.887% resulted in a sum of INR 13,631 in 35 years, while the same sum of INR 10,000 kept in the bank totaled INR  .

Now, imagine what INR 10,000 invested in SENSEX would amount to at 17% CAGR in 35 years? A whopping INR 2,435,034.74 (24.3 lakhs). So next time you wish to invest in gold, think again! And then think again until you’ve successfully talked yourself out of it.

2018-08-12T08:53:33+00:00July 23rd, 2018|4 Comments

4 Comments

  1. Mayank Bindra August 23, 2018 at 2:57 am - Reply

    Very informative & very useful to understand the dynamic of Gold Investing.

  2. Atish Lolienkar September 18, 2018 at 4:29 am - Reply

    Gold is the most important when it comes to investment. Gold has a very high liquidity compared to stocks. This can help you during your crises

  3. Nayana October 26, 2018 at 8:59 pm - Reply

    Well done , expecting more articles like this . Got required information from this article .Thanks you and keep up good work .

  4. nitin kumar November 10, 2018 at 5:45 am - Reply

    Rightly Said. i have been holding goodbess from last 5 years and the price is trading in narrow range. if i would have invested the same amount in stocks that would have appreciated a lot

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