In recent months, gold has caught the fancy of many an investor. And why shouldn't it? Gold prices have risen by over 17.80% in 2005 and more than doubled since September 2000 (See Table). And if the 'experts' are to be believed, there is a lot more steam left in gold prices.

The interest is palpable. But then, are people buying gold for the right reason?

Before venturing further into identifying the right reasons for individuals to buy gold, let's revisit the advantages and disadvantages of owning this commodity (yes, it is just that!). The main reasons why gold finds a place in the portfolios are:

1. Gold has historically proved to be a good hedge against inflation

2. It is liquid and can be easily converted into hard currency

3. It has ornamental value (more so for Indians)

On the other hand, investment in gold also has its disadvantages:

1. It does not provide regular current income like in the case of debentures which pay interest (gold bonds did not take off and lending of gold for a fee is not a viable option for retail investors)

2. It does not offer any tax advantages e.g. investment in a infrastructure bond entitles one to certain tax advantages

3. There is a possibility of being cheated with respect to the purity of the metal

4. There is a storage cost involved in preserving gold

All the points above are self-explanatory; except for the first advantage of gold, i.e. it is a hedge against inflation. Incidentally, this is probably the main reason why investors should invest in gold.

The general rise in prices, or inflation, can be understood as an environment where there is too much money chasing too few goods. The resultant rise in prices has a corresponding impact � a decline in the value of the currency as you start to pay more for the same product/service.

So, if you were paying Rs 20 per litre of petrol, you start to pay Rs 30 for the same quantity. This erosion in the value of the currency (in our case, the Rupee) is something investors should ideally guard themselves against. One way of 'guarding' your wealth is to hedge.

So how do you go about hedging to protect the 'real value' of your wealth? Invest in those assets/securities, which are either not adversely impacted by a rise in inflation or benefit from it. Prime amongst such assets/securities is gold.

Gold is a commodity the price of which is determined by various factors apart from its demand and supply. Also, it is a commodity that is priced in US Dollars as against our local currency (the price of gold is determined in international markets; domestic prices track the international price very closely).

What becomes apparent is that the factors that affect the price of gold are rather different from factors that affect other assets like say domestic fixed deposits. And therefore, if inflation in India were to dent the value of the Rupee, and consequently your wealth, it will have no impact on the price of gold (other factors remaining the same) thereby lending support to your wealth. In fact, in times of inflation, the smart money tends to move to gold, thereby driving up its price.

Over the last couple of years, crude oil prices have rallied sharply, resulting in a rise in inflation not only in India but globally. The impact however has been varied across countries depending on such factors as the stage of economic cycle they are in and their oil intensity (per capita oil consumption). This general rise in price levels has added to the attractiveness of gold.

One factor that plays a key role in determining the attractiveness of gold as an investment avenue is the currency. Gold is globally priced in US dollars; therefore if the value of the US dollar were to decline, then you would have to pay more dollars for the same amount of gold and vice-a-versa.

The rise and fall in the price of gold therefore may have more to do with the value of the dollar as against a fundamental change in the value of gold. Over the last couple of years, on a point to point basis, the US dollar has lost value against all major currencies of the world. The result -- US-dollar based gold prices have risen quite a bit; but the price of gold, denominated in the Euro for instance, has not risen by as much.

The preference for gold stems from the fact that it is readily available in a standardised form. Moreover, storage is not that big an issue as compared to, say, crude oil!

As mentioned earlier, at present the interest in gold as an investment destination is palpable. And unfortunately investors are being drawn to this asset only after it has witnessed a steep rise in prices.

In our view, gold is a must in every portfolio. However, the extent to which you should be invested in it should depend on your overall asset allocation.

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