Read a very interesting post in the Economic times a couple of days back. The author of the article compared the returns of gold with that of the stock market and concluded that stocks yield better returns in the long run. Data points are quite convincing but then they should! After all, world is filled with data which can support any theory. Only that we have to be smart to select those which suits us and hope that no one notices those which can prove the exact opposite. One of the favourite jokes among us academicians is that there is an equal and opposite thesis for every proposed thesis. Be that as it may, without offering solutions or tips, let me raise a few issues that bother me.
First issue is, how do we calculate long term returns on stocks? Most of the financial advisors will jump up and say "Use the index!" "Take the market capitalisation." Smart!!! The question which may arise is the dates of comparison. For example if I compare sensex of 1991 and sensex of 2011 I find that the composition has changed. Few of the original members now exist and so many new ones have come in. It is easy for the stock exchange to show the exit to one company and welcome the other. How easy is it for the investor to switch over? When does the investor switchover? Will the switching be neutral in costs? How easy is it for the investor to maintain a portfolio of stocks which mirror the sensex? When the index tracking funds run by well reputed asset managers do not match the gains or losses of the index how do we mere individuals who do not have similar resources do that? What happens if something like enron or satyam happens? The stock exchange will merely substitute the dud stock for a better one. Where does that leave us? These are existential issues which generally get brushed away in times of euphoria.
The next issue is the contradiction in comparing gold and stocks. Investment decisions in these classes are made with different considerations. Here I do not bring in those who are investing in gold for returns. They form a small portion of investing class. The gold bought by Indian citizens over decades and those held by central banks of countries is many times more than the quantum of gold held by exchange traded funds.
My logic says stocks and gold are two different asset classes existing at the opposite ends of investment spectrum. One is insurance (gold) and other is returns with risk (stocks). Can we compare the two? One deals with uncertainty and the other with risk. Is there a difference between uncertainty and risk?
Let me give the example of an insurance policy. The policy holder takes the insurance because of uncertainty. He does not and should not look for profits in the policy. The investment decision has been made because of uncertainty. What the policy does is to reduce that uncertainty and helps the policy holder to plan the future of his family with some degree of certainty. He can take some other investment decisions like house, retirement funds etc because the financial consequences of the uncertainty of life expectancy have been mitigated and addressed to a large extent. Look at the issue from the side of the insurance company. It does not sell the policy because of uncertainty issues. The selling decision is based on assessment of risk. It has the numbers which tell the company how many of the policy holders are expected to die and it needs to make full payments before the end of the policy. It prices that risk, calculates the premium, offers the policy to a group of people and still expects to make profit.
It is foolish for an individual to work out the statistical probabilities of his own death and plan for future without accounting for that event. Death occurs only once in his life whereas an insurance company can work out statistical probabilities of mortality. One death less or more will affect its profit margins. That is all.
Lesson: Risk assessment assumes that probabilities of all eventualities are known apriori. Uncertainty offers no such comfort. Gold provides insurance in times of uncertainty. Stocks offer returns with risks. All is well as long as we understand the difference.
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