HardAssetsInvestor

Why Does Diversification Work?

In the last article, we showed you that commodities zig when most other asset classes zag.

But why is that important? A quick glance at the chart below should show you how commodities can help out. The blue bars are commodity returns; the maroon bars are for stocks. See how often one goes up when the other goes down?

If all your portfolio were in stocks in 2002, you suffered. But look at how commodities performed ... while stocks fell more than 20 percent, commodities rose in value by 30 percent. If you had both, you were able to weather the storm and come out with more of your assets intact.

Commodities In Action

Why does this help? Let's take one example.

A typical diversified portfolio might be 60 percent stocks, 30 percent bonds and 10 percent T-bills. Over time, this would be a solid performer. But simply replacing 5 percent of the equity and fixed income allocations with 10 percent commodities has a subtle but real effect on the portfolio.

Here are the annual returns of those two hypothetical portfolios:

A quick glance shows that there's no free lunch: There are years where you'd be better off without the commodities exposure (generally in aggressively bullish equity markets). But for a long-term investor, the ability to diversify away the downside years while capturing the vast majority of the upside is a smart move. Here's why:

For one, it boosts long-term returns. The truth is that not losing money is much more important than making money. This is a critical and poorly understood point, but it becomes clear by using a simple example.

Suppose you invest $10 today, and it loses 10% of its value in year 1. You're down to $9. The next year, the portfolio rebounds and gains 10 percent. Great! Except 10 percent of $9 is only 90 cents, so you end up with just $9.90.

Diversification lets you make more money with less risk. That's a free lunch.

The ugly truth is that for every 50 percent you lose, you need to double your money (up 100 percent) to get back to even.

In the two portfolios shown above, loss avoidance improves returns: The commodities portfolio achieves 11.1 percent annualized growth compared with just 10.8 percent for the original portfolio. And yet, the risk of the commodities portfolio is lower: Its standard deviation is 9.8 percent vs. 10.6 percent.

What does that mean to your pocketbook? If you invested $100,000 in each portfolio at the start of this experiment, after 20 years, you'd have $752,706 in the straight portfolio and $761,112 in the commodities portfolio. Admittedly, that isn't a huge difference. But remember, you made that extra money with less risk. That's a free lunch.

Commodities Lower Risk

Here's the important thing to understand: In this example, adding commodity exposure to the portfolio has made it more conservative. This seems counter to what you read in the paper, which tells you that commodities are risky assets. But remember: We're not building a portfolio out of just commodities. We're using commodities with other asset classes to boost risk-adjusted returns.

Next Up: The Commodities Boom: Is It For Real?

Now we get to the other reason to buy commodities: Prices are booming.