While negative correlation is rare to find, gold is the perfect candidate for diversification as it has close to zero and sometimes negative correlation with the equity
Everyone knows the value of equity as an asset class for long-term wealth creation, but at the same time, volatility associated with equity leaves most investors under-allocated to the equity as an asset class. People can’t handle the roller-coaster ride of equity investing. Even those who are convinced about the long-term merits of equity investing, move out of equity after a sharp bout of volatility and periods of declining prices.
We have been witnessing one such period now. Now, if I tell you that it is possible to earn equity returns without bearing the risk of equity, you would think that I am an academic lecturing from the proverbial ivory tower. But believe me, I am not. There is a simple and easy way of achieving that.
Diversify with gold
For some reason, gold has not been the favoured asset class with investment advisors and it hardly gets its due allocation in most investment plans. But gold has a golden potential and may contribute wonderfully to the well-being of your portfolio. Assets with low or negatively correlated returns are the best candidates for diversification. And while negative correlation is rare to find (equity and G-Secs have a correlation of 0.15), gold is the perfect candidate for diversification as it has close to zero and sometimes negative correlation with equity.
You may still have a question in your mind: “Gold? Are you sure you want us to invest in gold? How much: 5-10% of our total investments?” No. I am talking about a portfolio of 50% equity and 50% gold! Where equity is represented Nifty Total Return Index (TRI).
Nifty Total Return Index
The graphic shows the performance of Nifty TRI and gold from November 2003 onwards. Gold has done much better than what most people would have thought. Nifty has delivered 14.98% of CAGR over 15 years with 27.12% of annualised volatility. This is just about 3% more than gold and that has come with almost double the volatility. But, as most of us would have expected, equity has delivered higher return with higher risk.
The passive portfolio created at the end of November 2003 with 50:50 split between gold and equity would have delivered 13.49% CAGR with 15.52% of annualised volatility. Almost zero correlation between gold and Nifty has done the trick. The return is obviously the average of gold and Nifty return but the risk has come down significantly. The power of diversification has played its role.
This is good but not magical, the risk has come down significantly but the return is just the average of gold and Nifty returns. Can we do something where we can get equity returns at gold risk? The answer is “Yes”. It requires a little effort at your end. You need to rebalance your 50:50 Nifty-gold portfolio at the end of every financial year to maintain a 50:50 Nifty-Gold allocation. And look at the result.
The CAGR has gone up to 14.6% which is as good as Nifty returns but with the volatility as low as gold. How is it possible? Is this just a fluke? The answer is “No”. You can estimate the annualised rebalancing bonus even before investing. The rebalancing bonus is:
1. Directly proportionate to Product of Proportion of funds invested in two assets
2. Directly proportionate to the riskiness of individual assets
3. Inversely proportionate to the correlation between the returns of the two assets.
The estimated rebalancing bonus for 50:50 allocations between Nifty and gold is 1.19% whereas the actual rebalancing bonus is 1.11% (14.6%-13.49%). So it’s almost on the target. You can estimate the potential rebalancing bonus for the pair of any two asset classes. There is more good news for gold investors. You can invest in gold at a 10% discount and can earn an annual interest on your gold investments.
The writer is professor & chairperson (Finance), School of Business Management, NMIMS, Mumbai