Gold or fixed income: Which is better to help diversify your portfolio?

Diversification across asset classes

It's fun to try new food recipes sometimes, but you would agree with me that they can’t beat your mom’s time-tested classics. For instance, fusion foods like cheese-stuffed parathas are definitely delicious, but that’s not something you can eat every day for breakfast, unlike the simple yet delectable aloo paratha.

A similar logic seems to apply to Indian investment portfolios. Most hybrid portfolios today, which are designed to benefit from a diversification strategy are allocated between equities and debt, leaving out the age-old investment asset class of gold. Like in other areas of life, we seem to be aping the West in the area of investing too.

Gold is…because rupee keeping depreciating

If one stops to reflect as to why western portfolios don’t have active allocations to gold, one realises that, unlike in India, they don’t have secularly depreciating currencies that continue to deplete their purchasing power. And that’s the precise economic rationale for why gold has been a prominent part of our culture historically, in addition to being a lender of the last resort. Currency depreciation has worked in our favor when it comes to returns from gold. Debt, on the other hand, has been a reasonable diversifier to equities for the West, as it is comparatively less sensitive to market movements and less likely to incur losses, which highlights debt’s role more from a stability perspective and less from a diversifying downside risk perspective. Also, this argument recently got tested with higher interest rates spelling trouble for both these asset classes, making them move in tandem.

If you check with your parents or grandparents, you will learn that gold was always a part of their investment plan, and it still is. As per a March 2022 report by Jefferies, 15 percent of total Indian household assets is invested in gold. Given its many benefits ― as a portfolio diversifier, preserver of purchasing power, and source of liquidity ― it's fair to say that Indians have got it right.

A 20-80 allocation

Given that the bulk of an average investor’s portfolio should ideally be invested in equities for long-term wealth creation, and the rest in an asset class that can help mitigate the volatility and risks associated with equity investing, we ran some numbers to understand which asset class could be an ideal diversifier to Indian equity investments. We assumed a 20-80 allocation between gold and equities in Portfolio 1, and a 20-80 allocation between debt and equities in Portfolio 2.

A 20-80 gold-equity portfolio over the 20-year period of 2003 to 2023 has yielded better returns than a 20-80 debt-equity portfolio. It has also been less volatile and seen lower drawdowns than its counterpart. Though debt’s standard deviation and drawdowns are the least among the three asset classes, it does not translate to the lowest standard deviation and drawdown when combined in a portfolio. While gold’s risk statistics on a standalone basis are inferior to debt, it has resulted in comparable or lower overall risks when combined in a portfolio with equities, making it a better diversifier.

If we dig deeper, it becomes apparent that over the last two decades, in years when equity markets gave negative returns of greater than -10 percent ― 2008 and 2011 ― debt did provide stability by yielding moderate positive returns, but it was gold that proved to be a true diversifier by giving double-digit positive returns of ~30 percent. Also, in years when equity markets gave disappointing returns of less than 10 percent, which does not compensate enough for the risk of investing in equities ― 2016, 2018, and 2022 ― gold compensated investors for the lower returns from equity, thus improving the portfolio’s returns compared to an all-equity or a debt-equity portfolio. Except in the year 2015, gold has proven to be a better diversifier than debt.

What should investors do?

So, over the years, while debt has become the preferred equity diversifier in Indian portfolios, it may be time to revisit some time-tested investment recipes. While debt is more stable than gold, which is prone to large price movements, gold has a much lower correlation to Indian equities which makes gold the better diversifier.

(The authors are Chirag Mehta, CIO, Quantum AMC, and Ghazal Jain, Fund Manager, Quantum AMC)