Commodities – They Have (Almost) No Place in Your Financial Portfolio

One of the things I really hate about the current Wall Street environment is how so many people have been fooled into thinking that commodities are a necessary part of your asset allocation.  I’ve been pretty hard on commodities over the years (see this detailed piece here).  I think it’s mostly just a ruse to sell another group of products and I think it’s really dangerous.  But even worse, I just think betting on commodities is fundamentally flawed thinking.  Not only are you speculating in a zero sum game involving production-less input costs, but you’re directly betting against human ingenuity.  I don’t like either of those bets.

If one actually takes a look at the long-term real returns of commodities you realize they’re actually quite dreadful.  Even if we cherry pick a decent period that includes a big boom like the last 20 years we still see pretty awful performance.  Over the last 20 years commodities have returned just 1.6% per year over the last 20 years.  That’s a real return of about MINUS 1%.

I prefer to think of commodities as something that are an input or a means to helping us innovate.  If you’re bullish on oil price dynamics you shouldn’t go buy barrels of oil and store them in a locker somewhere.  You should find the companies who leverage the use of that commodity and will benefit by innovating through the use of that input.  Don’t bet against innovation.  Bet on it.

Now, this doesn’t mean you shouldn’t own any commodities. In fact, a house is a pretty good inflation hedge because it’s a real asset with commodity inputs. But the question we have to ask ourselves if whether we’re buying commodities for the purpose of future production or whether we’re buying them with the expectation that someone will buy them at a higher price in the future? In the case of a house you are providing a valuable asset for yourself (or someone else). If you procure oil and produce gasoline to fuel cars you are providing a valuable service. But on its face, you shouldn’t invest in that oil with the expectation of speculating on its price. This, after all, is providing no real value to anyone and is nothing more than speculation on asset prices. That’s more akin to gambling than investing.

In my view it’s best to think of commodities (and things like gold) as super long duration instruments that will generally provide low real returns, but have the potential for asymmetric upside (for instance, during a very high inflation). In this sense, owning a small amount of commodities can be akin to owning insurance on your portfolio. It shouldn’t dominate your portfolio and there’s even an argument for no position in your portfolio, but if you want a long duration insurance instrument with the potential for asymmetric upside at times then commodities can make sense. But you shouldn’t start the portfolio construction process around this asset.

Sensible portfolio construction starts with understanding the role of specific assets in the economy and how those various assets fit into your portfolio in particular ways.  I don’t know why this theme of commodities as an asset class has taken off over the last 10 years, but it sure doesn’t seem to be helping anybody except those selling the idea….