I was recently asked in an interview if one can replace fixed income in a portfolio with gold. The answer is a BIG NO!
Gold is a commodity and a separate asset class. It is not a replacement for equity or fixed income in an investment portfolio. To understand this, we should first appreciate how assets are classified.
The classification is done in terms of risk and not returns. Equity, gold or fixed income can give negative or positive returns. What sets them apart is the risk. This can be measured in many ways. The most common is the standard deviation (how much prices deviate from a mean price) and the drawdown (how much the asset falls from a maximum and how long it stays underwater).
The 15-year rolling risk (standard deviation) of Sensex TRI, gold INR and IBEX Gilt Index
You can see that gold is way more volatile than a long term gilt index (the most volatile fixed income asset).
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Maximum drawdown of Gold INR, and Sensex TRI IBEX Gilt Index
Gold prices fall significantly more than bond (fixed income or debt) prices and stay underwater (that is below a previous maximum) for years!
Therefore, never assume gold is a replacement for fixed income. It is a unique asset class. It is as volatile as equity. The key difference is that equity is driven by hope and optimism, while gold is driven by fear and pessimism.
Q: Can I add some gold for “diversification”?
A: You can, but a 10% or 15% exposure will not make a big difference to your wealth. Also, if you do not know how to rebalance between equity, gold, and fixed income and are reluctant to do so for some reason (well, tax), then you are better off not having gold.
If you “must” have gold exposure, make an equity-oriented multi-asset fund a central component of your equity portfolio (in addition to a good amount of fixed income via separate instruments). This will take care of the rebalancing headache.
15-year gold INR returns have been single-digit in the past (when inflation and fixed income returns were double-digit). So, do not expect gold to be a “hedge against inflation” at all times. Sometimes it will and sometimes it will not!
You must be prepared for the risks if you want a slice of the shiny metal’s return. Are you? Most investors are not.