Commodities (gold, oil) are a poor strategy for portfolio diversification
Interestingly, what’s written below doesn’t recommend never investing in commodities – but that one should do so for the right reasons (you have good intel on where the price is going, or you wish to invest in a specific commodity producer).
It was an idea inspired by Ivy League research. The research said that enhancing your portfolio with a splash of commodities — things such as gold, oil and pork bellies — could allow you to reap stock-like profits while providing a safe harbour during market downturns.
It sounded lovely in theory. But commodity investing flopped in practice. Despite a mild recovery, broad commodity indexes are still below their levels of 2008. Rather than being a counterbalance to equities, commodities have bounced up and down in tandem with Wall Street.
To understand how important the fine print is, go back to 2006, when two Yale professors published one of the most influential finance papers in years.
Gary Gorton and Geert Rouwenhorst examined 45 years of market history and concluded that investing in commodity futures, while using U.S. treasury bills as collateral, produced returns just as good as putting money into stocks. Even more enticing was their conclusion that commodities tended to do well when stocks did badly.
To institutional investors, this was catnip. Putting money into commodity futures –contracts for the delivery of commodities in months to come — looked like the perfect way to balance the risks in the stock market.
Within months of the paper’s publication, money managers were searching for easy ways to invest in commodity futures. Fund companies obliged them by creating specialized exchange-traded funds (ETFs).
The new ETFs got off to a roaring start as money poured into what appeared to be a sure bet. Then the stock market sank in mid-2008. This was when the Yale professors had predicted that commodities should shine.
Commodities did no such thing. They plunged in line with the stock market, then struggled to recover only part of their losses. So much for big gains and reducing risk. What went wrong? One theory blames the global recession. Another theory is that the flood of money into commodities changed the nature of the market.