We always seem to hear about commodities when they have done really well, which is no different than anything else in finance. Commodities differ from a lot of other strategies you hear about in one important way: they are, as their name indicates, commodities, which means they are standardized, interchangeable goods.
A barrel of West Texas Intermediate crude oil is exactly the same as any other barrel of West Texas Intermediate crude oil. An ounce of gold is the same as any other ounce of gold. Standardization lets the commodities markets operate effectively. Everyone knows exactly what is being bought and sold.
But commodities are just things. They don’t produce any value in and of themselves. They’re valuable, but they don’t create new economic activity. In short, they don’t increase the size of the pie. Buying a commodity is fundamentally different than investing in a company. Companies are going concerns. The whole point of a company is that it creates economic value (or at least it’s trying to). Companies want to increase the size of the pie.
In practical terms, this means that the long-term expected return of commodities is inflation. Commodities are basically moving along with inflation—at least over the long term. What makes people get so excited about commodities every once in a while is their massive volatility.
And after doing a whole lot of analysis they come up with the following conclusion:
When we break everything down, commodities don’t help us with any of the competing factors we look at during portfolio construction. They have lower long-term returns than short-term fixed income. They have higher volatility than the stock market. And they don’t help us hedge against inflation.
Unless we are able to predict what they are going to do going forward (and we certainly can’t), there is no reason to want them in your portfolio. In nearly all cases over the long term, commodities will lower your portfolio’s return and increase your portfolio’s volatility.
It may be boring, but the standard, broadly diversified stock and bond portfolio built around taking an appropriate amount of risk for you is still the best solution for helping you meeting your goals. And that’s what investing is all about—meeting your goals, not shooting for a high score.
I would like to echo that last line. Investing is about meeting goals – not being the best!