What to Consider When Investing in Commodities

(MoneyWatch)  I did a quick search on Google News this morning about commodities investing. The top result was a USA Today article that discussed how using commodities as a hedge against inflation may have poor results. However, the second choice was an article from Kiplinger's touting new investments that "deliver stable and solid returns" through commodities.

With so much differing information out there, it's easy to see why some of you may lose sight of the role commodities should play in your portfolio. As I outline in my book The Only Guide to Alternative Investments You'll Ever Need, there are a few considerations before investing in commodities.

• A small allocation of commodities can serve as a diversifier of risk.
• While they have historically been a good diversifier, that isn't always the case.

Regarding that final point, consider the following. In 2008, the DJ-AIGCI and the GSCI (the two main commodities indexes) fell 35.7 percent and 46.5 percent, respectively. It got even uglier in the first three months of 2009, with cumulative losses reaching 39.7 percent for the DJ-AIGCI and 52.2 percent for the GSCI. Making matters worse was that this happened during a period when equities were experiencing their worst loss since the Great Depression.

Periods where both stocks and commodities have fallen have happened before. In 2001, the S&P 500 Index fell 11.9 percent and the GSCI fell 31.9 percent. In 1981, the S&P fell 4.9 percent and the GSCI fell 23 percent. Whenever, we experience deflationary type recessions it is logical to expect that both stocks and commodities will perform poorly. Thus, commodities hedge some portfolio risks, but not all.

But again, commodities have generally served as a good diversifier. Since 1973, there have been nine years when the S&P 500 showed a loss. In the three years mentioned above when commodities also showed a loss, the S&P 500 averaged a 17.9 percent loss and the GSCI a 33.8 percent loss. But in the other six years, the GSCI showed considerable gains. While the S&P 500 had an average loss of 13.8 percent in those six years, the GSCI had an average gain of 39.3 percent. Not only did the GSCI provide portfolio insurance in two-thirds of the years the S&P 500 was down, but the gains were considerable.

While it is important to avoid getting caught up in the noise of the moment, this is a good time to review the case for including an allocation to commodities as an effective diversifier of portfolio risk. The bottom line is that I think there is a compelling case for doing so.