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Should You Own Commodities in Your Portfolio?
By William Hutchens

The prime rule for successful long-term investing is to have a diversified portfolio. To most investors, when talking about diversification, usually implies that diversification is by type of investments and type of assets. But the real foundation of the concept is correlation. If two investments are highly correlated, they move pretty much in tandem. When investments are weakly correlated, they move generally in the same direction but not equally as fast or as far.

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When investments are negatively correlated, they move in the opposite direction of each other. If we design a portfolio that is too highly correlated, we run the risk of having too many eggs in one basket. That’s ok when things are going in the right direction but really bad when things are moving against you; that’s why having investments that vary in correlation is important. And that is why having some commodities in your portfolio makes sense. You see, commodities are negatively correlated with equities and bonds. That is to say, if equities are moving down, commodities are normally moving up and vice versa. This helps to smooth out returns over the long term.

A recent study of correlations between different investment types showed that commodities were negatively correlated with all normal forms of equity investments (stocks, bonds, mutual funds). But even more impressive from the standpoint of portfolio construction and optimization, commodities have shown a 5 year average return of 13% and that does not include the recent run-up in commodities in 2007 and the first half of 2008. So, this means that commodities are not only negatively correlated with equities but also provide for average returns equal to or superior to the returns of the general equities markets.

No doubt, when most investors think of commodities, they think of crowded trading pits, chaos, confusion and stories of millions lost and made in the time it takes to eat your lunch (or have it eaten by traders on the other side). Moreover, the idea of a long-term investor, who usually buys and holds for an extended period of time, trading commodities sounds very much out of character. And indeed, it is.

But without going into the peculiarities of trading commodities, there are ways for more conservative investors to participate in commodities without having to trade them. And as we have seen, a limited exposure to commodities is good for asset diversification and risk reduction because commodities are negatively correlated with most other investment types.

So, what are some of the ways for a non-commodities trader to invest for the long term in commodities? First of all, an investor can invest in commodity related companies such as found in the energy, chemicals and precious metal sectors. Secondly, and growing in popularity, is to invest in managed commodity funds. However, in both cases, it’s a good idea to seek professional guidance when choosing one of these options.

Yes, even though the commodities bull is out of the barn, it’s not too late to add some commodities to your portfolio. It’s a solid strategy over the long run. Today, many investment professionals feel that energy and agriculture sectors are particularly attractive for commodity investors but over the long term, there is no doubt that raw materials will always play an important part of the World economy and their negative correlation with equities make for a good balance in any portfolio.

So, the answer to the title of the article: Should You Invest in Commodities is a resounding, YES!