Commodities Create the Right Mix

By Jarecki, Henry G. | Futures (Cedar Falls, IA), February 2007 | Go to article overview
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Commodities Create the Right Mix


Jarecki, Henry G., Futures (Cedar Falls, IA)


Most investors want to improve the overall return/risk profile of their portfolios. They want lower volatility, smoother returns and to decrease the possibility of large losses. Modern portfolio theory holds that risk can be reduced significantly by diversification among noncorrelated assets.

Investors would prefer not to sacrifice returns to lessen risk through asset diversification and so they look for uncorrelated assets with a positive return. That is why many have come to invest in tangible commodities. Tangible commodities belong in any portfolio devoted to maximizing return while minimizing risk.

THE DRUNK IN A FIELD

Back in 1900, the French mathematician Louis Bachelier identified how much someone could win or lose while trading if there was an equal probability of price changes up and down, and how soon such gains or losses would occur. He based his ideas on the principles of heat diffusion described nearly a century earlier by Joseph Fourier. In 1905 two English scientists, Karl Pearson and Lord Rayleigh, discussed the concept of what soon thereafter came to be known as a "random walk," with Pearson noting, "In an open country the most probable place to find a drunken man who is at all capable of keeping on his feet is somewhere near his starting point."

Bachelier's work can be used to determine how long it will take such a drunken man to wander off the field onto the surrounding superhighway where he can be hit by a truck. The smaller each individual step is, the closer he will be to where you left him. The bigger his steps and the longer you leave him, the greater the chance he will wander into danger. Lowering volatility makes each step forward and backward smaller. Analogously, if your total portfolio moves up and down in smaller steps, it is likely to last longer - long enough, hopefully, to let its basic positive return emerge before it is hit by the truck of chance.

The best way to lower a portfolio's volatility is to add uncorrelated assets to it. A 50/50 mix of two uncorrelated assets, both of which have an ultimately positive return, will not only have a positive return but a far smoother one as well and thus a higher Sharpe ratio.

This is the secret of diversification: that returns of a portfolio consisting of numerous uncorrelated assets will be cushioned when one falls while the others rise or stay the same. That is why old-timers say that diversification is the only free lunch in investing.

For this reason, and because the choice of asset class has a greater effect on returns than the choice of any particular member of that class - and is indeed responsible for as much as 90% of returns - many investors and portfolio managers focus on choosing the type and percentage of asset classes rather than on specific stocks, bonds or commodities. In fact, adherents to the capital asset pricing model believe that transaction costs would make selecting individual assets inefficient compared to using an index.

Academic interest in portfolio construction, diversification and managing risk advanced along with the speed of computers in the 1970's, resulting in a good understanding of asset allocation as applied to stocks and bonds, but not to commodities. Investors have traditionally owned stocks for appreciation and bonds for stability, but the idea of having commodities in an investment portfolio is relatively new. Only gold has had a long history as an investment. Other tangible commodities such as cattle, copper and cotton were not considered for investment purposes until the past 15 years or so.

Before that, theoreticians, investment institutions and their advisors knew little about tangible commodities - and the little that they thought they knew was that commodities were far more volatile than stocks and that most commodity investors went broke. It was probably true that most commodity investors lost money, but this was not due to any inherent danger.

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