Portfolio Diversification

Commodities' low historical correlation with other asset classes suggests that an allocation to commodities can potentially improve the risk-reward trade-off of a traditional portfolio of stocks and bonds.

• Diversification is a tool used to optimize portfolio performance and maximize risk-adjusted returns. Diversification tends to smooth the volatility of a portfolio and produce performance that is more consistent.

The primary reason that diversification tends to reduce risk is that the strategy aims to select assets that will not all react the same way to changing economic conditions. The goal is to prevent one badly performing asset or sector from having a significant, adverse effect on the overall portfolio.

Commodities tend to bear a low to negative correlation to traditional asset classes like stocks and bonds.

• Correlation Coefficient-
  
  • Is a number between -1 and 1 that measures the degree to which two variables are linearly related. If there is perfect linear relationship, you will have a correlation coefficient of 1.
  • A positive correlation means that when one variable has a high (low) value, so does the other. If there is a perfect negative relationship between the two variables, you will have a correlation coefficient of -1.
  • A negative correlation means that when one variable has a low (high) value, the other will have a high (low) value.
  • A correlation coefficient of 0 means that there is no linear relationship between the variables.

Typically, U.S. equities whether in the form of stocks or mutual funds are closely related to each other and tend to have positive correlation with one another. Commodities, on the other hand, are a bet on unexpected inflation and they have a low to negative correlation to other asset classes.

Commodities have offered superior returns in the past, but they still are one of the more volatile asset classes available. Make no mistake, they do carry a higher standard deviation (or risk) than most other equity investments. However, by adding commodities to a portfolio of assets that are less volatile, you actually decrease the overall portfolio risk due to the negative correlation and in most cases increasing your overall expected return

Diversification does not guarantee a profit, nor does it guarantee protection against a loss. Past performance is no guarantee of future results and commodities may not have low correlation with other asset classes in the future.