How Much Should You Have in Commodities?

Alexander Green
by Alexander Green, Chief Investment Strategist, The Oxford Club
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I'm often asked how much of an investor's portfolio should be in commodities. If you're a trader or speculator, that's up to you.

But a long-term investor with a five-year-plus horizon? Virtually none. (The commodities allocation in our Gone Fishin' Portfolio, for instance, is zero.) Here's why...

It's not unusual to hear reports in the media from time to time about how human beings are "using up" the world's resources or that we are "running out of oil." Don't believe it. And certainly don't bet on it.

Price Pressure

Innovation and technology undermine prices for most commodities. We've seen this in agriculture, where irrigation, mechanization, genetic modification, and new pesticides and fertilizers all boost productivity.

Sure, you've seen coffee shoot up over 90% this year and hog futures climb nearly 50%. But these are one-offs. The spike in coffee is due to a drought in top exporter Brazil. And a virus that has killed millions of pigs is behind the run-up in pork bellies.

The same is true of "peak" theories of oil and gas. It seems like only yesterday that the national media was reminding us about our "addiction" to foreign oil. But new technologies like fracking and horizontal drilling have boosted production sharply. Last year we surpassed Russia as the biggest producer of oil and gas in the world.

The prophets of doom never foresee the new advances and increasing efficiencies that undermine future scarcity. When whale oil began to run out, we started using petroleum. When farm yields stalled, new fertilizers were introduced. When glass fiber debuted, demand for copper fell.

Yes, raw material prices had a good run from 2000 to 2010. The Dow Jones-UBS Commodity Index more than doubled. Copper gained 417%. Cotton jumped 184%. But that was when China - which consumes 40% of the world's commodities - was growing at more than 10% a year. That's not the case today.

And commodity prices - which had a lousy three decades in the run-up to 2000 - are back under pressure. Yes, they're up a bit this year, but they plunged 9.5% in 2013, lagging stocks, bonds and real estate badly.

Not a Diversifier

Some pundits - especially those who sell commodity products for a living - insist that raw materials are a good diversification. They're not. To own them, you have to take money out of stocks and bonds, both of which have handily outperformed commodities over the long haul.

Moreover, 17% of the market value of the S&P 500 consists of companies in energy, utilities and basic materials. So you likely have exposure to commodities - and these companies often turn a profit even if prices stagnate.

How about as an inflation hedge? There hasn't been much inflation to hedge lately. Sure, you can point to higher prices at the pump or the doctor's office. But I'll point to lower prices (and far superior quality) on homes, cars, electronics and more.

Even if inflation does raise its ugly head again, raw materials are hardly the only - or the best - inflation hedge.

Your home is an inflation hedge. Treasury Inflation-Protected Securities (TIPS) are an inflation hedge. And, unlike gold or commodities, TIPS actually guarantee that your money keeps pace with inflation, something gold hasn't done over the last 35 years.

(I'm not arguing against gold, incidentally, something you should hold in your portfolio for the same reason you keep a spare tire in your trunk.)

But a substantial allocation to commodities? Only if you're a speculator playing with money you can afford to lose.

Good investing,

Alex

Editor's Note: Alex has developed a recommended asset allocation that helps guide many of The Oxford Club's recommendations. For a closer look, click here.

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