Commodities and Portfolio Diversification

The wisdom or the need to diversify is a topic that gets discussed a lot when looking to manage one’s portfolio, and most people at least have some idea as to why this is considered to be so important.

If we just always sought to maximize investment returns, then this would miss entirely the other side of portfolio management. Diversification is part of the broader concern of exercising proper risk management, as diversification seeks to limit the risks that our portfolios may be exposed to.

We don’t just want to be diversifying for its own sake, and any diversification that we seek must be viewed as to how well it accomplishes its goal of reducing our risk. We also need to be aware of alternative approaches to managing risk, and see diversification as just one of several tools that we may use to achieve this goal.

Commodities and Portfolio DiversificationA lot of investors feel pretty good about how well their portfolios may be set up to manage risk, mostly because they just believe everything the investment industry tells them, that there are certain criteria that need to be met and you’re basically all set.

This is not really the case though, and most people aren’t protected very well at all, because they are guided by those who really don’t have much of an interest in it. If your financial advisors are mutual fund salespeople, expect to be sold, but don’t expect much in terms of real guidance in risk management.

Regulators at least pretend to help, with their concepts of what they feel should be suitable for particular investors, but merely trying to measure one’s extreme risk tolerances isn’t risk management, as the risk itself and one’s tolerance to it aren’t the same thing at all.

What it takes to break you and leave the fund and the risks that you should be taking or how you manage them aren’t the same thing.

In the end, what people get is a watered-down form of risk management that does promote certain forms of diversification, but little else. Staying fully invested with them is a given, and they just look to work around that to seek to avoid the things that would cause you to take your money elsewhere, perhaps by mixing in enough bonds so that the pain is tolerable once it comes.

It is at least as important to manage risk well as it is to manage returns well, and we need a good measure of both if we want to both grow and protect our savings properly. Diversification can be a good tool to use to help with this, and diversifying with commodities is a tool that is under utilized.

The Common Approach to Diversification

The first thing that we’re told is that we shouldn’t have all our eggs in one basket so to speak and we should diversify our stock holdings across many companies and several sectors. This is certainly not a bad idea, and the more good companies we invest in, the less we are at risk for specific issues relating to them. The more sectors we invest in, the less we are exposed to sector risk.

While these are two risks that we should be managing, perhaps paying the price of shooting for a little lesser return in exchange for more stability, this certainly doesn’t leave our stock positions hedged, and far from it.

The biggest risk by far with investing in stocks is market risk, and all of your stock holdings are exposed to this. When bear markets come, the great majority of stocks decline along with the market.

Looking to diversify with a broad range of stock holdings actually increases market risk. If you go with the strongest stocks, and are less diversified, this may take the bite off of bear markets if anything. When the decline is broad, and your holdings are broad, it becomes even more likely that you will bear the full brunt of these moves against you.

The real problem here is that a lot of investors are lulled into an overblown sense of security by thinking that a well diversified stock portfolio provides much hedging at all. They end up buying into the notion that if you are in for the long run and you have the time, you should just grin and bear it. Company risk and sector risk are managed, and there’s no need for them to worry about market risk.

Those who may not have the time to ride out long bear markets are offered a little protection by way of asset diversification, where we assign certain percentages of one’s portfolio to bonds instead of stocks. This does add some stability by eliminating some market risk, although we still tend to neglect most of it, even in situations where clients do not have much time to deal with bear markets, such as retirees being still exposed to them to significant degrees.

We even see people in advanced age who hold large portions of their portfolio in stocks, at a time where having any exposure to this doesn’t really make sense, where they are relying on spending a good portion of their capital which is exposed to significant market risk.

Perhaps the market will keep going up through their final years, or perhaps it won’t. Proper asset allocation concerns itself with what will happen if things don’t work out so well, and to use diversification properly, we need to seek to help protect people against less than ideal outcomes.

Using Commodities to Enhance Diversification

Different asset classes have their own particular risks. With stocks, the risk is of course that the value of our holdings will decline. This is, by the way, apart from whether we can manage to hold them until they come back, as drawdown risk is a concern all by itself, in spite of this being ignored so much.

If your stock portfolio loses half its value for instance, the fact that it has lost so much matters and matters a great deal regardless of whether it regains its value in 10 years or whatever. The risk of this happening is called drawdown risk, and the money lost is actually lost in spite of whether the money is made later.

It isn’t just a matter of wondering how appropriate it is to continue to hold something that long when things are going against us so much, we must also look for ways to try to deflect at least some of this drawdown by diversifying in other assets, particularly those that tend to go up when stocks go down.

Those who have professional asset management tend to focus more on the benefits of diversification in assets other than stocks and bonds, and while bonds can cushion the blow somewhat, commodities like precious metals tend to do an even better job at this in times of need.

The downside here, with inverse relationships like this, is that the commodity side of your portfolio will often bring down your returns during bull markets with stocks, and the reason is that during good times, people invest less in commodity hedges and during bad times they invest more in them, which causes them to move in different directions a lot of the time.

If some people invest more in commodities during bear markets, and less during bull markets, investors more sophisticated than the average investor that is, why is the average investor not seeking to take a similar approach?  The average investor though isn’t taught to think, they are taught to just obey, and it’s just more expedient to put them into fixed strategies that don’t seek to adapt to anything.

Commodity hedges can serve investors quite well or even extremely well if used properly. It is a good idea to have some of this hedging going on at all times, as markets aren’t predictable enough to say that the need for this hedging isn’t there to some degree at all times, but it is certainly wise to look to seek to vary this according to need.

Trading Commodities as Diversification

For those who are a little more ambitious with their portfolios, they may wish to seek to devote part of their portfolio to either trading commodities, or if their portfolio is large enough, to have others do it for them.

Trading anything isn’t for the uninitiated though, and especially commodities trading, and the goal here should not to be to take on excessive risk as one would if one sought to do this without enough training and experience.

This is perhaps as far from buying and holding mutual funds as you could get, and people certainly want to lose the idea that trading is easy and practically anyone could do it. Practically anyone can, but there are some real skills involved in trading commodities, the biggest of which is managing the risks involved.

Some instead think that in order to profit trading commodities, you are going up against industry insiders and professional traders, both of whom are much better situated than ordinary folks, who really have no chance in this arena.

Traders all have their own agendas though, and trading merely pits the trader against the market, which is not such a formidable foe as many think. A random approach with zero skill will break even, flipping a coin to go long or short for instance and using some randomly set time to stay in it, and one just has to profit enough to cover trading costs to break even completely.

One can leave the nuts and bolts here up to commodity ETF managers and just trade the ETF, which is a good idea for most people since the much higher leverage of futures markets should be reserved for those who have proven skills.

Engaging in some trading in addition to one’s investments can certainly add both diversification and spice to one’s overall portfolio, although this does require that one’s trades be actively managed. This can be done in various time frames though, one can look to even hold positions for a year or two if desired, while letting the performance of the trade ultimately dictate the period.

As one becomes more skilled in trading, one may end up taking a more active and a more sensible approach in managing both the returns and especially the risk of one’s portfolio overall. This may disappoint their so-called investment advisors somewhat, but being more in control of your future, as long as this is done with skill and knowledge, certainly can be a good thing.

Ken Stephens

Chief Editor, MarketReview.com

Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.

Contact Ken: ken@marketreview.com

Areas of interest: News & updates from the Federal Reserve System, Investing, Commodities, Exchange Traded Funds & more.