Posted in Finance Articles, Total Reads: 1573
, Published on 11 October 2012
Human wants are unlimited, once a want is satisfied another immediately crops up and in order to meet the ever increasing demands we need to have financial backing. Only a single source of income cannot meet this demand, so what to do? Simple, INVEST!! Yes, Investments are not only a source of savings but also a mode of increasing your income, and earning from various sources. This brings us to our topic of Investment vehicle, i.e. assets in which one should invest so that his/her earnings get maximized, which is the sole objective of any investor.
There are number of asset classes in which one can invest i.e. one can invest in:
a) Market securities- Shares, Debentures etc.
b) Real estate- Land, Plots, Flats etc.
c) Commodities – Gold, other metals, etc.
There are numbers of assets in which one can invest, so how does one go about investing? Simple the one which gives the maximum returns, isn’t it? No it is not how one should invest without taking into account other factors like risk factor, diversification in investments which would be discussed later in the article. Yes it is important that asset which gives maximum returns should be sought. Now the question arises which asset generates the maximum returns. Here is the information given below:
Name of the asset class
Average return for past 5 years
It has been seen that gold has given 21.28% on an average for past five years outperforming other investment vehicles like market securities and real estate. Let us discuss Gold as an investment vehicle in detail. Today gold is a hot topic for speculation and a very highly demanded asset the reason being it’s higher returns and higher degree of safety as compared to any other asset class.
Out of all precious metals, gold has been the most popular since ages. Today investors generally buy gold to hedge or harbour against economic, political or social crises including (currency failure, inflation, burgeoning national debt). It acts as a safeguard against all odds in the financial markets and various crises in the nation. Gold over the years has gained and retained its value which gives a sort of comfort to the investors who prefer stability, lower risk along with a good return. The other big advantage of investing in gold is that of its negative correlation with the stock markets which means that whenever stock markets performs badly the returns on gold investment shoots up hence this is a better option for a diversified portfolio.
The term ‘diversification of portfolio’ has gained a significant importance in today’s investment strategy because the markets are uncertain. Hence, you need a well diversified portfolio which can maintain your earnings in form of returns with low chance of making losses on investment. Suppose you have three stocks which are unrelated to each other’s performance & hence have a negative correlation, so if one underperforms the other two will do fairly well thus reducing the risk of loss. But if they are related to each other then, the one which underperforms would affect the earnings of other two and hence it is not a wise step to hold all related stocks.
Below is illustrated an example of well diversified portfolio which shows how having gold in your portfolio can help you to maintain your steady income while lowering your market risk.
Mr. Ghanshyam Burnwal is an investor with a portfolio of Rs 1million which is distributed like this:
Equities( Infosys Shares)
Plot at Bhawanipore Market ( Kolkata)
The Std. Deviation (risk) of each investment class is:
a) Equities = 12%
b) Real estate = 7%
c) Gold = 3% and,
Correlation between investment classes is:
a) Gold & Equities = -0.8
b) Gold & Real estate = 0.7
c) Real estate & Equities = -0.2
Now the average return is considered as returns of the investment classes which are (rounded of):
a) Gold = 21%
b) Real estate = 14%
c) Equities = 15%
Now the return of the portfolio:
Returns = (15% * 0.3) + (14%*0.3) + (21%* 0.4)
= 4.5% + 4.2 % + 8.4%
(0.3, 0.3, 0.4 being the respective weightage of the stocks in portfolio)
Risk(in Var) = (weight of G)2 * Var( G) + (weight of E)2* Var(E) + (weight of RE)2* Var(RE) + 2* (weight of G)* (weight of E)* SD(G)* SD(E)* Corr(G&E) +…..( for two others)
= (12.402)1/2 (since it is variance and risk is calculated as SD standard deviation)
RE= real estate
Var = variance= (SD) 2
Corr = Correlation of two stocks
Thus we can see that individually investing in stocks entails higher risks and lower returns but having a diversified portfolio can reduce the risk form 12% to close to 3.5%, and the returns turns out to be 17.10%, look at it carefully, correlation of gold and equity is negative hence it pulls down the risk so having gold in your portfolio not only reduces the risk but also enhances your return thus diversification of portfolio with gold is a wise step to take.
One can say why should one have a portfolio when the return on gold is high than portfolio return plus the risk is also lower than portfolio risk, well good observation but there are some catches to it, gold only performs better when stocks are not doing well and hence this is the probable reason why gold has given highest returns in the past few years but once the stocks performs well then the return on the gold seems to go down so one can never only rely on gold. Moreover, the prices of gold has risen suddenly and it is not a cup of tea for small time investors to invest heavily in it thus they have to rely on other investment vehicles and can only have a bit of gold to push down the risk factor.
Now we know that having gold in our portfolio is a sign of a better investment skills, now we need to understand the form in which one should purchase it? There various methods of purchasing gold are:
a) Gold Bullion Coins: These are the kind of gold coins which are considered to be pure than other forms of gold, and they are kept as a store of value rather than trading day to day. A very famous form of investing and one of the first form still prevalent today.
b) Pooled Accounts: Here the investor purchases physical gold but doesn’t have it in his custody, rather it is with the gold dealer and investor can very well sell it as and when he feels, it is a cheaper and safer method of investing in physical gold.
c) Gold ETFs: These are also known as paper gold, which are generally open ended mutual funds, where one unit represents one gram of gold. You can buy and sell it as any other stocks in the market.
d) Gold Mining Stocks: It is basically investing in the shares of the gold mining companies, where the return and risk are both much higher than other forms of investment. Hence it is a risky venture and a person with a good risk appetite opts for this method.
e) Derivatives: These are basically financial market instruments such as forwards, futures, put option, call option in which gold is traded as any other stock in the market.
In a nutshell, gold is the most important investment vehicle, which can be bought & sold as simply as any other stock, and is a must for every investor who wants to maximize his wealth, because come what may it will deliver returns for sure. But one should not solely concentrate on gold as it has flaws which can prove fatal; hence it is advisable to have gold in your portfolio along with other securities.
This article has been authored by Gurcharan Singh from Praxis Business School, Kolkata.