For years now I’ve been recommending commodities in some form or another as a means on increasing diversification in investor’s portfolios. Most advisors that do, recommend between five and ten percent of a portfolio is such investments. For many, it is understood that they are important to include. For others, not so much.

What are commodities? I found this on the web; “Commodities — such as precious metals, including gold and silver; industrial materials, such as iron ore and copper; and agricultural products, such as wheat and pork bellies.” For more details, here is one popular index and here is another.

Why commodities? First, they can offer strong diversification benefits to an investment portfolio. Roger Gibson, the author of the must read book “Asset Allocation: Balancing Financial Risk,” shows that including some portion of commodities in your portfolio of well diversified equity, bonds, and real estate produces better compound average returns–higher, risk-adjusted returns.

However, doing so is counter-intuitive. Including an asset class that has relatively low performance and high volatility arguably increases the risk-adjusted returns of the whole. How is that? Well, in short because of the volatility of commodities, they provide more opportunities to sell high and buy low.

Second, commodities can be a safe haven during tough markets. Not always, but most recently we saw commodities outperform the S&P 500 from 2007-10. And again last year commodities bested the market. That means during four of the last 10 calendar years, commodities bested equity. It is precisely during the times of uncertainty and market fluctuation, we want asset classes that act differently.

Third, commodities provide better performance during times of unexpected inflation. Just like to drive to gold during rough times, commodity prices react more quickly to unexpected inflation. In this article by PIMCO, they discuss the nature of sudden prices changes in food and energy and how holding commodities can benefit. And in the Credit Suisse article the authors explain how a basket of commodities, as apposed to a single asset like gold, offer purchasing power protection against inflation.

Is everyone convinced? No. A quick internet search will provide you with several articles and white papers explaining that commodities are not for everyone. And, in this article by Chris Gaffney, president of the World Markets division of EverBank, Chris explains “now is the time to add commodities”. You know my investment philosophy, we can’t guess the future. Mr. Gaffney’s mention of market timing makes me shudder. You would have done well if you had commodities last year. Well, better late than never.

I agree they are not for everyone. However, I also believe that while frustrating at times, having them in your portfolio will benefit you in the long run if part of a well diversified portfolio that includes cash for your near term needs, bonds for stability, US and International equity and real estate for long-term growth, and convertible bonds for both growth and income during these times of low yield.

If you don’t hold them you may consider adding a small slice to your portfolio. While we don’t know what this year has for us, we do know that commodities were the best performer last year as noted in my previous newsletter. And for those of us that hold commodities, it may be time to trim some during our normal rebalancing effort. Invest well my friend. Dan

 Image from OptionSellers.com