Why we still don’t favor commodities

Do commodities have a rightful place in a broadly diversified portfolio? The obvious answer seems to be yes, they do. However, after a lot of careful study and thought we have concluded that the right answer is still no, they don’t.

Commodity prices across the board are at all time highs. Experts say the world is running out of natural resources and that production will not keep up with the rising demand from fast growing emerging economies.

From a portfolio point of view, commodities also have attractive characteristics. While commodity prices are quite volatile, they tend to zig and zag independently of stock and bond prices. Due to the uncorrelated price movements, adding a small amount of commodity exposure can actually lower overall portfolio risk for a given expected return.

There is also a small measure of portfolio insurance gained from commodity exposure. During a rare commodity-related crisis, such as the Arab oil embargo in 1973, a dramatic rise in commodity prices will help buffer the decline in both stocks and bonds. Commodity exposure can also provide some insurance against political risk, since many of the nations currently rich in natural resources also tend to be somewhat politically unstable.

For all of the reasons briefly described, we were keenly interested in adding commodities to our model portfolios. This was a hard problem with many subtleties and conflicting expert opinions to work  through. Contrary to our expectations, after careful study, we recommend leaving commodities out of a diversified investment portfolio. (more…)