Adding commodities to an investment portfolio can help diversify your portfolio while providing the additional benefit of inflationary protection.
Every investor knows how beneficial it can be to have a well-diversified portfolio.
When a portfolio is well diversified, some securities will rise under certain conditions, while other securities fall under the same conditions.
The idea of diversification is to find non-correlated securities that will rise and fall in value at different times.
An investor does not want "all their eggs in one basket" (highly correlated securities) because there is the potential to lose everything all at once.
Proper diversification can help protect against various risks in the market place.
These risks are called diversifiable, or unsystematic risk.
When one company in your portfolio suffers from a firm-specific event such as a lawsuit, labor strike, or regulatory action that negatively effects their competitive advantage, that event will not dramatically affect a well-diversified portfolio.
However, there are some risks that cannot be diversified away.
These are call non-diversifiable, or systematic risks.
Systematic risks are those that affect the entire marketplace.
These can include natural disasters, wars, political events, and others.
Often times these events can be difficult to predict, and can have troubling affects on even a well-diversified portfolio.
One type of systematic risk that can be anticipated, and can be hedged against, is inflationary risk.
This is the risk that the return on your investments will be eroded by rising inflation.
As inflation rises, your purchasing power decreases, i.
e.
the money you have does not buy as many goods or services.
If you have a long-term investment that returns 10%, but inflation increases 5%, then you actually only earned 5% on your investment over that period (in inflation adjusted terms).
So how does inflationary risk affect your portfolio, and what can you do to protect your investments during a period when inflation is on the rise? If you have a portfolio consisting entirely of stocks, then you should be alright.
Corporate revenues and earning tend to rise at roughly the same pace as inflation, since companies simply increase their prices to offset their rising costs.
Companies that hold huge cash reserves, such as Microsoft, tend to get hit harder by inflation because they lose purchasing power on their cash holdings.
By analyzing a company's financial statements, one can generally predict how a company will be affected by inflation.
Inflation will hit an investor who holds fixed-income securities, such as bonds, pretty hard.
If you purchase a 20-year bond yielding 10% for $1,000, then you expect to receive $1,100 in 20 years, thus earning 10% on your investment.
However, if inflation rises 7% in those 20 years, then you actually only earned a 3% inflation-adjusted return on you investment.
If you are investing during a period of "stagflation" then you need to be even more prudent with your investments than during times of traditional inflation.
Stagflation occurs when prices are increasing, but the overall economy is not expanding.
For example, 2012 is expected to be a year of stagflation.
Countries around the world have accumulated massive amounts of debt.
As these nations are forced to adopt austerity measures in order to remain solvent, global economic growth with lag for several years to come.
At the same time, the massive influx of capital in the global markets (from central banks simply throwing money at debt problems) is effectively increasing the prices of goods and services.
All of this paints a textbook example of stagflation.
Stagflation affects bonds roughly the same way as regular inflation, as purchasing power decreases with overall price increases.
However, stagflation has a negative effect on stock prices.
When an economy is struggling to grow, demand for goods and services tend to remain low.
When demand is low and prices are high, companies are taking on additional costs for doing business, but are failing to increase revenues and earnings.
Thus, a company's margins will be negatively affected by stagflation, and their stock price will fall.
In order to protect against inflation and stagflation, a savvy investor will add commodities to their portfolio.
Commodities are a great addition because they are generally not highly correlated with other assets, so they add a level of diversification.
Additionally, commodities tend to increase in value when inflation rises.
So, commodities will hedge against the negative effects of price increases within an investment portfolio.
Every investor knows how beneficial it can be to have a well-diversified portfolio.
When a portfolio is well diversified, some securities will rise under certain conditions, while other securities fall under the same conditions.
The idea of diversification is to find non-correlated securities that will rise and fall in value at different times.
An investor does not want "all their eggs in one basket" (highly correlated securities) because there is the potential to lose everything all at once.
Proper diversification can help protect against various risks in the market place.
These risks are called diversifiable, or unsystematic risk.
When one company in your portfolio suffers from a firm-specific event such as a lawsuit, labor strike, or regulatory action that negatively effects their competitive advantage, that event will not dramatically affect a well-diversified portfolio.
However, there are some risks that cannot be diversified away.
These are call non-diversifiable, or systematic risks.
Systematic risks are those that affect the entire marketplace.
These can include natural disasters, wars, political events, and others.
Often times these events can be difficult to predict, and can have troubling affects on even a well-diversified portfolio.
One type of systematic risk that can be anticipated, and can be hedged against, is inflationary risk.
This is the risk that the return on your investments will be eroded by rising inflation.
As inflation rises, your purchasing power decreases, i.
e.
the money you have does not buy as many goods or services.
If you have a long-term investment that returns 10%, but inflation increases 5%, then you actually only earned 5% on your investment over that period (in inflation adjusted terms).
So how does inflationary risk affect your portfolio, and what can you do to protect your investments during a period when inflation is on the rise? If you have a portfolio consisting entirely of stocks, then you should be alright.
Corporate revenues and earning tend to rise at roughly the same pace as inflation, since companies simply increase their prices to offset their rising costs.
Companies that hold huge cash reserves, such as Microsoft, tend to get hit harder by inflation because they lose purchasing power on their cash holdings.
By analyzing a company's financial statements, one can generally predict how a company will be affected by inflation.
Inflation will hit an investor who holds fixed-income securities, such as bonds, pretty hard.
If you purchase a 20-year bond yielding 10% for $1,000, then you expect to receive $1,100 in 20 years, thus earning 10% on your investment.
However, if inflation rises 7% in those 20 years, then you actually only earned a 3% inflation-adjusted return on you investment.
If you are investing during a period of "stagflation" then you need to be even more prudent with your investments than during times of traditional inflation.
Stagflation occurs when prices are increasing, but the overall economy is not expanding.
For example, 2012 is expected to be a year of stagflation.
Countries around the world have accumulated massive amounts of debt.
As these nations are forced to adopt austerity measures in order to remain solvent, global economic growth with lag for several years to come.
At the same time, the massive influx of capital in the global markets (from central banks simply throwing money at debt problems) is effectively increasing the prices of goods and services.
All of this paints a textbook example of stagflation.
Stagflation affects bonds roughly the same way as regular inflation, as purchasing power decreases with overall price increases.
However, stagflation has a negative effect on stock prices.
When an economy is struggling to grow, demand for goods and services tend to remain low.
When demand is low and prices are high, companies are taking on additional costs for doing business, but are failing to increase revenues and earnings.
Thus, a company's margins will be negatively affected by stagflation, and their stock price will fall.
In order to protect against inflation and stagflation, a savvy investor will add commodities to their portfolio.
Commodities are a great addition because they are generally not highly correlated with other assets, so they add a level of diversification.
Additionally, commodities tend to increase in value when inflation rises.
So, commodities will hedge against the negative effects of price increases within an investment portfolio.
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