Diversify Your Portfolio With Commodities

In volatile times, investors often flock to investments with perceived safety.  These investments include short-term treasury bills, precious metals such as gold, and hard assets such as real estate and commodities.  All of these asset classes have a place in a well-diversified and balanced portfolio.   Commodities in particular offer an interesting investment proposition.  On their own, commodities exhibit wild price swings and have long-term returns approximating the long-term rate of inflation.  As part of a larger portfolio, however, they can offer valuable diversification benefits.

Hard Assets

A commodity is an every-day product that is traded on one of the global commodities exchanges.  Orange juice, lumber, cattle, oil, gold, wheat, and aluminum are all examples of publically traded commodities.  Commodities differ from most other asset classes in that they do not generate income.  Stocks, bonds, and real estate all generate streams of income in the form of earnings, interest payments, rents, etc.  Commodities, on the other hand, do not generate income.  They are merely bought and sold at differing spot prices in response to global supply and demand.

One advantage of commodities is that they tend to be poorly correlated with other asset classes such as stocks, bonds, and real estate.  Historically, commodities as a group have been almost entirely uncorrelated with these more traditional asset classes and mixing low and uncorrelated asset classes are the cornerstone of constructing a diversified portfolio.  In periods of high inflation, for instance, commodities tend to perform well while stocks and bonds falter.  Thus, commodities can provide invaluable inflation protection and hedge against falling stock prices.  Since most companies’ input costs are tied closely to the price of commodities, it makes intuitive sense that a rise in commodities prices would squeeze corporate earnings.

Commodities and Your Portfolio

So how much of your portfolio should you devote to commodities?  Because commodities tend to have low long-term returns, I would invest just enough to achieve a moderate short-term hedge against inflation.  In my opinion, despite the diversification benefits, you should devote no more than 5%-10% of your portfolio to commodities at the absolute most.  Some ETFs you might consider are the iShares S&P GSCI Commodity-Indexed Trust (GSG) and, if you want to balance out the large stake in the energy sector most commodities ETFs possess, the PowerShares DB Agriculture ETF (DBA).

For a detailed discussion of investing in commodities and some of the finer points of their supply and demand characteristics, you should check out Hot Commodities: How Anyone Can Invest Profitably in the World’s Best Market by Jim Rogers. Jim, a noted expert in the field and out-spoken advocate of commodities investing, writes in a way accessible even to novice investors. I highly recommend at least a passing familiarity of his work and ideas to all investors.  If nothing else, it will add to your knowledge of global supply and demand.