Does Commodities Investing Mean Too Much Diversification?

(MoneyWatch)  I came across a newsletter article that asked if you could have too much diversification. In the article "Too Much of a Good Thing?," the author shows the risks and returns on investments in stocks, bonds and commodities since 1991 and concluded that you should not invest in commodities.

However, the author failed to look at allocations to commodities in the proper context. Here's how you should look at commodities and why the academic evidence favors adding an allocation.

The issue of whether you should include an allocation to commodities in your portfolio is one of the most hotly debated topics among investors, advisors and even academics. Those that argue against the use of commodities generally show evidence such as this. These returns are for the period January 1991-June 2009.

	Annualized Return	Standard Deviation
S&P 500 Index	7.9%	16.2%
MSCI EAFE Index	5.2%	18.3%
Five-Year Treasury Notes	6.6%	5.6%
20-Year Treasury Bond	8.7%	10.2%
S&P GSCI	3.1%	23.6%

On the surface, commodities look like a poor investment. They had the lowest return and highest volatility of the other asset classes in the group. The author of that newsletter article made a similar argument. However, looking at investments in isolation is the wrong way to look at the problem. You should look at the impact an allocation to commodities would have on a portfolio.

So let's look at how the addition of a small allocation of commodities impacted the risk and return of a portfolio, using the same time frame as before:

• Portfolio A holds 60 percent stocks (36 percent S&P 500 Index/24 percent MSCI EAFE Index) and 40 percent Five-Year Treasuries.
• Portfolio B takes 5 percent from our equity holdings and adds an allocation to the S&P GSCI Index.
• Portfolio C shifts the fixed income allocation to 20-Year Treasuries.

For Portfolio C, we can extend the maturity of our fixed income holdings because the S&P GSCI has exhibited negative correlation (-0.3) with longer-term bonds. In fact, in each year from 1970 through 2008 that longer-term bonds produced negative returns, the GSCI rose and had an average return of 30 percent. During the first half of 2009, the 20-Year Treasury lost 13.7 percent while the S&P GSCI rose 6.6 percent.

	Portfolio A	Portfolio B	Portfolio C
Annualized Return with Quarterly Rebalancing	7.2%	7.2%	8.2%
Annualized Standard Deviation	9.2%	8.6%	8.7%

Despite the S&P GSCI's lower returns and higher volatility, Portfolio B produced virtually identical returns but exhibited about 7 percent lower volatility. Portfolio C produced higher returns than either portfolio and did so with lower volatility than our portfolio without commodities. And it was the addition of the commodities exposure that made it prudent to take the incremental maturity risk of the 20-Year Treasury bond.

On Friday, we'll take a look at further evidence for including commodities in your portfolio. Also, you can check out the chapter on commodities in my book The Only Guide to Alternative Investments You'll Ever Need.