Have you often heard financial experts recommending gold investments while speaking about a diversified portfolio? Have you ever wondered why?
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Well, gold investments are known to be the best way to reduce your share market losses and hedge inflation. In India, gold has a significant market presence and it is an important asset class that serves to mitigate the economic and share market fluctuation due to features like liquidity and returns on investments. Let’s delve into a deeper study to understand how it helps you fight inflation:
Gold investments are one of the best ways to hedge inflation. As you may know, cash reserves or equity investments suffer the hardest hit during inflation. The purchasing power of cash reduces during inflation, similarly, equity investments are likely to underperform during inflation. Inflation can also affect the returns from other financial assets in case the moderate return does not keep up with the price hike or the rate of inflation.
For example, if you have saved money in a fixed deposit at an interest rate of 6% per annum and the inflation in the economy is 8% per year then the rate of returns is not inflation-beating. Investments that are linked to the stock markets are likely to witness a fall during a period of inflation. So high inflation works to reduce the pace of the economy and lowers its GDP.
On the other hand, high inflation is likely to support the demand for gold bullion and physical gold as inflation makes fixed-income assets less attractive to investors.
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Gold not only appeals to traditional investors who use it as an instrument for wealth accumulation but it also has a good position in the financial portfolios of modern investors. The value of gold is recognized throughout the world and the liquidity it offers attracts investors of all kinds.
Also, if we look at the past performance of gold, we see it has always been a safe investment during share market uncertainty. The demand for physical gold always results in a higher price. Since it is a luxury item, the price of gold tends to increase with a rise in the price of living that usually results from inflation.
Thus gold is an excellent hedge to inflation and it is often used by investors to safeguard investments against share-market volatility and economic turmoil. In India, gold has performed well and has also given good returns to investors. The currency depreciation in India can also be hedged by gold investments. Reports by the world gold council show that for every 1% rise in inflation, the gold demand rises by 2.6% in the Indian markets.
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Here is how inflation impacts various asset classes:
Equities: when the economy suffers high inflation; the central bank tends to hike the interest rate to reduce the cash flow in the economy. Such measures are implemented to bring inflation under control. Consequently, it impacts the borrowing capacity of most of the firms operating in the economy. Thus its profits get affected and thus the prices of the stocks reduce at the stock market.
Currency: high inflation results in lowering the purchasing power of the local currency and thus it depreciates.
Bonds and fixed deposits: the prices of bonds and the returns generated from it bear an inverse relationship with a rising interest rate in the economy. High inflation tends to raise the interest rate thus decreasing the prices of the bonds.
Commodity: as inflation rise, the prices of commodities increase thus decreasing the purchasing power of money. The buyers are able to purchase lesser commodities either by paying the same or higher price.
Gold: gold is the best hedge to inflation and have historically performed well and is likely to be in demand in future. The reason why gold has fared well so far is due to its limited supply. As gold is known to carry cultural significance it is in high demand. The relation between demand and supply determines the price of any commodity. And thus gold has maintained its price despite market fluctuations and fall in currency price.
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This is the reason traditional investors prefer investing in gold as it never loses its value in the market. As time passes more and more currency is required to buy gold thereby pushing its price higher and higher. Since gold is also a precious metal its worth not only depends on the cost of production but also on global macroeconomic developments.
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