Even as they tiptoed around stocks, pulled money out of mutual funds and reduced contributions to small savings schemes this past year, Indians accumulated enough wealth to make huge bets on one asset class — gold. They poured a mind-boggling sum of $38 billion (roughly Rs 1,70,000 crore at today's exchange rates) into gold jewellery, bars and coins in 2010, estimates from the World Gold Council suggest. The sum that Indians invested in gold in that single year was higher than the assets managed by all equity mutual funds (Rs 1.6 lakh crore) and stood at a fourth of the sums held in small savings schemes.

Chasing returns

That Indians are buying up gold for its virtues as an investment, rather than for adornment, is clear from the way demand has behaved relative to prices. Traditionally, Indians were savvy buyers of gold; they cut back on their jewellery purchases if gold prices spiked. But there has been a sea change in that trend in the last year or so; Indian jewellery demand surged by nearly 70 per cent , even as gold prices made new lifetime highs. Now, this behaviour is peculiar for a consumer, but is very much the norm for a retail investor. If we're buying consumer goods, we scout for discounts and bargains. When it comes to investing, we buy more of the asset that has seen its prices soar!

Gold can be risky too

The above shift in the allocations, has several implications for investors. One, though gold in small doses is a good diversifier for the portfolio, they need to be wary of downside risk to gold prices. Unlike equities, mutual funds or fixed deposits, gold doesn't generate any regular income and relies entirely on price appreciation for returns. True, steadily rising prices have ensured that gold has turned out to be a splendid investment in recent years, its 18 per cent annual return since 2008 trouncing the Sensex' 12 per cent and well ahead of the 8 per cent earned by fixed income options. It has also performed well when stocks didn't. However, the price moves on gold are the result of many factors: gold's demand-supply equation, the prospect of central bank purchases or sales, speculative interest and that ephemeral thing called global “risk appetite” which decides whether money floods into risky options or flees to safe havens. Many of those factors have favoured gold in the past three years; but whether they will continue to do so, no one can tell. This makes gold just as risky to bet on as stocks or other commodities.

Two, like every other commodity, and quite unlike stocks, gold has no valuation benchmark underpinning its price. Hence, even as gold is poised at $1500 an ounce or thereabouts, it is impossible to gauge if it is over-valued or under-valued, relative to its fundamentals.

Three, of all the means available to actually invest in gold, jewellery is one of the most inefficient. The costs incurred towards making charges and taxes while buying jewellery, the lack of means to assess its purity and the deduction of hefty wastage on resale may wipe out a good portion of the investment returns that one makes from gold. Nor is all this investor fancy for gold a great thing for the Indian economy. Given that India relies on imports for nearly ninety five per cent of its annual gold requirement, jewellery purchases result in flight of wealth from the country.

The PAN factor

In fact, one factor that may at least partly explain the recent fancy for gold as an investment could be that transactions in gold jewellery have so far escaped the taxman's eagle eye. While a PAN number has been mandatory for some time, for most investments and big ticket purchases, gold jewellery alone has been free of this requirement until recently. However, this loophole has recently been plugged. Effective July 1, quoting the PAN number has become mandatory for all gold or bullion purchases of the value of Rs 5 lakh or above. Will the prodigious appetite for gold hold up after these changes? That will determine the nature of India's demand for gold in recent times.

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