X

Sign up for Equitymaster's free daily newsletter, The 5 Minute WrapUp and get access to our latest Multibagger guide (2018 Edition) on picking money-making stocks.

This is an entirely free service. No payments are to be made.


Download Now Subscribe to our free daily e-letter, The 5 Minute WrapUp and get this complimentary report.
We hate spam as much as you do. Check out our Privacy Policy and Terms Of Use.
Is your Fixed Deposit better than Gold? - Outside View

Helping You Build Wealth With Honest Research
Since 1996. Try Now

  • MyStocks

MEMBER'S LOGINX

     
Login Failure
   
     
   
     
 
 
 
(Please do not use this option on a public machine)
 
     
 
 
 
  Sign Up | Forgot Password?  

Is your Fixed Deposit better than Gold?
Aug 2, 2010

"Why should I invest in Gold? It does not even offer me a regular source of income like bonds or deposits," asked an investor. "With deposits, I can actually calculate the returns which I will surely receive at maturity," he added.

I answered him with a question in return, "Tell me, would you invest in an instrument that actually gives you negative returns?"

"Absolutely not;" was the answer.

Quite often, while the rate of interest on investments like those mentioned above, may be a positive number, the 'real' rate of return earned, when looked at practically, may actually end up negative.

How can this happen?

Real rate refers to the returns that you get after subtracting inflation. The negative returns that we spoke of earlier, comes into play when the interest rates are lower than the increase in cost of living. This means that your earnings from fixed income instruments is not able to keep pace with the increase in expenses.

In financial terms:



In times like NOW, when we are facing negative real interest rates, your (nominal) capital's growth is constantly eroded by the loss of purchasing power.

A little detail on this front:


For e.g.: If nominal interest rates = 6% and inflation = 14%

Then, real interest rates = 6-14 = -8%

Chart: Real interest rates and Gold (India)
Source: Bloomberg
* Real interest rates have been calculated using SBI 1year deposit rates and CPI Index|
** Gold prices are in Rupees per ounce and does not include any levies, duties and taxes


Understanding the link

Nominal interest rates cannot be negative, because then you as an investor would simply prefer to hold cash instead of moving to deposits / bonds. Correct? But, real interest rates can turn negative, and quite often too.

Technically, real rates are also positive. Debt investors deserve to earn a positive real rate of return, because they too have taken a (counterparty) risk with their hard-earned capital. Yes, their risk may be lower in comparison to stock investors, but then to be fair, shouldn't they be compensated for it, no matter how little the risk involved? In the case that they are not suitably compensated, they will invest less over the long term, once they realize that they are risking their (scarce) capital for a guaranteed loss.

Would you loan money to anyone if you knew you would take a real loss for doing so? Most definitely not.

In order to promote growth, central bankers tend to force nominal rates so low that real returns plunge negative, thereby making debt investing a losing proposition.

If real interest rates turn extremely negative, investors would start moving their capital to hard assets i.e. commodities in order to protect their purchasing power. However storing tangible goods is quite a cumbersome and expensive task, and in the case of intangible services, this is not a real possibility.

In such a scenario, investors gradually turn to gold.

Gold is a time-tested asset which protects your purchasing power over the long term. While bonds guarantee a real loss, gold will (at least) keep pace with inflation to preserve the purchasing power of your capital. Hence, when central banks attack debt instruments, investors gradually forsake losing bonds and eventually migrate towards gold. The longer the duration for which bonds give negative real returns, the more capital gradually takes refuge in gold.

The 1970s

In the US, 1970s brought in inflationary times, when the cost of living exceeded the nominal returns available on bonds. It was seen then that debt investors, gradually shifted their capital to gold. These investors drove a strong gold bull market in an attempt to protect their purchasing power.

Chart: Real interest rates and Gold (US)
Source: Bloomberg


The classic bull run of the 1970s ended after policymakers were forced to dramatically hike interest rates. Only once interest rates increased to healthier levels of more than 4%, did investors shun gold and re-migrate to bonds.

And Now

In an effort to bail out speculators and the so called "too big to fail" and highly levered financial institutions, the US federal government (Fed) has embarked on an easy monetary policy. They have forced the benchmark interest rates to zero and thus lowered the cost of funds. This has led to a dip in real interest rates and has opened out realistic returns for bond investors.

However, the Fed seems to have trapped itself - lower cost of funds is necessary to repair their balance sheets and support their functioning - Any increase in borrowing costs will be a burden whose weight may threaten the so called 'ongoing recovery' - While an action to raise rates would prove healthy over the long term, this is apparently unacceptable politically.

As long as the Fed controls nominal rates to levels under headline inflation, real rates are going to remain negative. Investors are increasingly shifting to gold in order to protect themselves from the theft of monetary inflation and to avoid losing real purchasing power year after year by investing in bonds.

Even though gold doesn't pay a yield, as long as it merely paces with inflation it is a much better investment than bonds that lag behind price rises.

Do Investors have an option?

Negative real interest rates prevail in an environment of low growth expectations and high uncertainty. Low growth expectations would discourage spending and induce households to save, thereby driving interest rates lower. On the other hand, risk premiums usually increase in light of high uncertainty in the economy. This leads to heightened risk aversion leading investors to seek more safe assets, which in turn drives down the return on safe assets.

Both forces seem to be working now and are likely to persist going forward too.

Investors have two choices to opt for:
  • Hold cash in form of deposits which guarantees a loss of real value; or
  • Invest in gold which preserves your purchasing power and maintains the value of your money
Moving into gold seems to be the rational and practical approach and as realisation dawns, this shift of money into gold will only drive gold prices to much higher levels. Disclaimer:
The Golden Truth is authored by Chirag Mehta. Chirag is Fund Manager - Commodities at Quantum Mutual Fund. Views expressed in this article are entirely those of the author and should not be regarded as views of Quantum Mutual Fund, Quantum Asset Management Company Private Limited and Equitymaster. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Equitymaster has not verified the facts contained in this column and it does not accept any responsibility for the same. Please read the detailed Terms of Use of the web site

Equitymaster requests your view! Post a comment on "Is your Fixed Deposit better than Gold?". Click here!

  

More Views on News

Two Meetings That Nailed the Idea of Owning Brilliant Smallcaps Without Buying Them (The 5 Minute Wrapup)

Mar 22, 2018

Certain blue chips hold the potential of delivering returns comparable to small-cap stocks. With these stocks, you can get the best of both worlds.

What They Forgot to Tell You About Sensex at One Lakh (Profit Hunter)

Nov 29, 2017

Stocks that could beat Sensex returns in the long term.

How I Got My Wife To Invest In Mutual Funds... (Outside View)

Jul 20, 2018

PersonalFN brings to you a real-life case of how husband and wife engaged in a sensible money-talk post-marriage to build a solid mutual fund portfolio.

Our Newest "Fixer-Upper" (Vivek Kaul's Diary)

Jul 20, 2018

Bill Bonner talks in detail about US president been accused of treason, biggest debt default in China, the problem of growing inflation and the trade war.

The 'Profitable' Ola and Uber You Can lnvest In Right Now (Profit Hunter)

Jul 20, 2018

Here's is a business in small cap space that is asset-light and yet profitable - A serious contender for the list of future blue chips.

More Views on News

Most Popular

How to Avoid a 90% Loss Suffered by This Super Investor(The 5 Minute Wrapup)

Jul 12, 2018

Blindly following super investors is a dangerous game to play. Here's how you can avoid such mistakes.

The Answer to Your Wealth Worries: Small Caps (Especially Now)(Profit Hunter)

Jul 10, 2018

If you're worried about the markets - you are on the wrong track. This is opportunity - put your wealth-building hat on, instead - Richa shows you how...

The Multiple Problems with the Minimum Support Price (MSP) System(Vivek Kaul's Diary)

Jul 11, 2018

The price signals that MSP sends out, creates its own set of problems.

ICICI Pru Mutual Fund Tarakki Karega! - The Unethical Way?(Outside View)

Jul 11, 2018

PersonalFN explains how ICICI Prudential Mutual Fund flouted the norms of related party transactions while subscribing to the IPO of ICICI Securities.

PPF v/s Mutual Funds: Which Is Better?(Outside View)

Jul 10, 2018

PersonalFN highlights the key points of distinction between PPF and mutual funds.

More

Small Investments
BIG Returns

Zero To Millions Guide 2018
Get our special report, Zero To Millions
(2018 Edition) Now!
We will never sell or rent your email id.
Please read our Terms

S&P BSE SENSEX


Jul 20, 2018 (Close)

MARKET STATS