You may not realize it, but your asset allocation is your single most important investment decision, responsible for as much as 90% of your portfolio’s long-term return.
Asset allocation, of course, refers to how you divide your portfolio among different noncorrelated asset classes, including large and small cap stocks, foreign and domestic equities, high-grade bonds, high-yield bonds, and inflation-adjusted Treasurys.
(Noncorrelated means these investments don’t all move in the same direction at the same time. When some zig, others will zag.)
Readers occasionally ask why I don’t include commodities among our recommended asset classes, especially since a slew of new index-based products make commodities more liquid and investable with each passing year.
The answer is they don’t add value.
That’s surprising to many, especially since oil, natural gas, wheat, soybeans and coffee periodically make dramatic runs higher.
But they generally don’t over the long haul. And there’s the rub.
Unlike stocks and bonds, commodities don’t accrue interest, generate earnings or provide dividends.
To make money, you generally need an imbalance of supply and demand. For example, flooding in the Midwest has delayed plantings this year, pushing corn to a near five-year high.
Unfortunately, it would have been difficult – make that impossible – to predict this weather in advance.
Some advisors recommend commodities as an inflation hedge. Indeed, higher food and energy prices are sometimes primary drivers of inflation.
Yet over long periods, stocks – the highest-returning asset class of all – are far better.
Or, if you don’t like the volatility inherent in equities, you can buy Treasury Inflation-Protected Securities (TIPS) and get a government-guaranteed return that exceeds inflation – though just barely.
Another hurdle for commodity investors is high expenses.
Most commodity mutual funds and exchange-traded funds (ETFs) don’t actually own the soybeans, natural gas or metals they track.
Instead, they own contracts that give them the right to buy those commodities at a set time in the future. As the contracts mature, they “roll” them into later months.
But this is costly, and funds that invest in commodities often have expenses 15 to 20 times higher than stock and bond ETFs.
However, the real reason to give commodities a miss is that – despite their volatile nature – they don’t give good returns.
In 1980, economist Julian Simon made a famous wager with Paul Ehrlich, the gloomy “futurist” and author of The Population Bomb, a book that argued that world population growth was outstripping the fixed supply of resources and would soon cause a global economic catastrophe.
Simon was skeptical and bet Ehrlich $1,000 that any five raw materials he selected would be lower 10 years later. Ehrlich agreed and chose five metals he expected to undergo large price increases: chromium, copper, tin, nickel and tungsten.
Between 1980 and 1990, the world population grew by 800 million, the biggest increase in history.
Yet each of Ehrlich’s selected metals dropped. (In the case of tin, more than 50%.)
Thanks to technology and substitution, commodity prices tend to decline from high levels and, in fact, have not even tracked inflation over the long haul.
Indeed, the Goldman Sachs Commodity Index (GSCI) – consisting of 24 commodities, including energy products, industrial metals, agricultural products, livestock products and precious metals – is barely higher than it was two decades ago.
Of course, most investors already have indirect exposure to the commodity markets through the stock market.
If you own a plain-vanilla S&P 500 index fund, for instance, 14% of that money is invested in basic materials and energy companies.
The difference is that commodity-based firms – like gold miners and oil and gas exploration companies – can boost profits by increasing production, cutting costs or both.
In short, commodities – with the exception of gold – are not a buy-and-hold asset class.
And trading commodity futures – or options on futures – is a good way to get an expensive education.
In short, most investors can and should give commodity investing a miss.