Pushing gold, without knowing the risks

It has been around for thousands of years, does not decay and is widely seen as a store of solid value and a hedge against inflation. More and more Indians are being lured into buying physical gold, trading in gold exchange-traded funds (ETFs) or trading in e-gold. Financial products, however attractive, are synthetic, whereas you can touch and feel gold. It has a strong emotional appeal for all, especially Indians, who have been buying, gifting and hoarding gold for ages. To add to this, over the past decade, gold has witnessed a massive bull run. Gold today has everything going for it — great history, great recent past and great present. Gold buying for investment has picked up a brisk pace. After all, it has gone up three times in the past five years.

Mutual funds are launching exchange-traded funds; wealth managers are pushing all kinds of gold; commodity brokers are encouraging trading in gold futures; gold companies are advertising gold loans and raising money from the public; and even stock exchanges are aggressively goading people – through spam emails and physical camps – into buying gold. Gold must be part of your investment portfolio.

Well, all popular investing processes are beset with myths, false beliefs, untested assumptions and lack an understanding of financial history. And this applies to gold as well.

At the time of writing, on Wednesday evening, gold fell four per cent and silver six per cent in less than an hour — and nobody knows why. Indians are not used to such steep declines in gold prices, not for extended periods. They see gold as attractive and safe; they believe that gold, like real estate, always increases in price over time. The fact is that gold crashed from $850 in January 1980 to about $300 in 1985, eventually bottoming out at $257 in late 2001.

We, in India, did not feel this crash and underperformance for two reasons. One, we pay for gold in rupees, not dollars, and the rupee had weakened from Rs 8-9 to the dollar in 1980 to Rs 44 by 2001. So a 70 per cent crash was more than compensated by a 500 per cent weakness to the rupee over 21 years. Two, gold was not an object of speculation through futures, ETFs and so on back then; gold was not “financialised”. Gold was bought and held in physical form, which was akin to buying real estate. Even if the value of your property goes down sharply, you do not feel the crash because you have paid for it fully and are prepared to wait. If you buy property through ETFs or borrowed money or buy real estate futures, it is a different story. You will feel compelled to check the prices every minute, feel terrible and may be driven to buy and sell. This may be good for your stockbroker and the exchanges, but not for you.

Gold has gone up continuously since 2001. Price rises often feed on themselves and are then supported by untested logic. Ask anyone why gold prices are rising, and the two most common reasons are: one, demand from India and China; and two, the weakness of the dollar. Well, there are two reasons gold prices go up and down: the buying and selling by central banks and the movement of real interest rates in the US. There is a third reason now: the financialisation of gold through ETFs which is pushing up the price of gold. Have mutual funds, gold loan companies, exchanges and investors thought through how these will play out?

Gold had a manic bull run in the 1970s, followed by a crushing bear market in the 1980s and 1990s, followed by a big bull market that is continuing now — because the real interest rate of dollar assets like US Treasuries is low and running close to, or below, inflation. When this happens for long periods, investors seek “hard assets” like gold and real estate. Gold offers no income and emerges as a negative choice over the choice of your income eaten up by inflation.

As an aside, at various times in history, the close correlation between negative real interest and gold prices has been mistakenly seen as a correlation between inflation and gold. But if inflation is six per cent and US Treasury yields nine per cent, the holders of US Treasuries are enjoying a real interest income of three per cent and, in that case, gold will not go up on investment demand — even though inflation has sharply moved up to six per cent. At various times, gold has failed to be a hedge against inflation.

I have not come across any investor even being made aware of any of these factors and what happens to his or her gold investment in different scenarios. In the best case, gold will continue to rise due to the weakness of the dollar and negative interest rates. In the worst case, interest rates in the US pick up, gold prices fall, money moves out of gold ETFs, leading to a further fall in gold prices, the rupee remains steady and we get the full impact of a gold price crash for the first time in our lives.

If this happens, stockbrokers will shrug and sell you the next hot thing, mutual funds may want to sell real-estate ETFs, while exchanges and regulators will say (if they deign to communicate): didn’t you know what you were doing? That would be one more instance of a repeating pattern: of self-serving financial companies bringing in hot investment ideas without even caring to know the risks; of regulators playing along thinking all this is so benign; and of savers trusting both and getting burned.



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