Role of Commodities in Portfolio Diversification

You’re building a diversified investment portfolio — you need a mix of stocks, bonds, and real estate. But, what happens when the stock market experiences a major downturn?

Bonds and real estate might also be negatively affected, causing your portfolio to suffer significant losses.

This is where commodities can play a crucial role. By adding commodities to your portfolio, you create a buffer that helps reduce the overall risk and increase the potential for returns.

What is Portfolio Diversification?

Portfolio diversification is an investment strategy that involves mixing different asset classes to reduce risk. The idea is that by holding a variety of uncorrelated assets, the overall volatility of your portfolio will be lower. In this context, commodities like gold, silver, oil, and agricultural products provide an additional layer of diversification.

Why Commodities Matter for Diversification:

1. Low Correlation with Other Asset Classes:
Commodities tend to have a low or negative correlation with traditional asset classes like stocks and bonds. This means that when stock markets fall, commodities might rise, or vice versa. For example, gold often performs well during periods of economic uncertainty or inflation, while equities may struggle.

Example:
During the 2008 financial crisis, while equity markets suffered massive losses, gold prices surged as investors sought safe-haven assets, making it an excellent diversifier.

2. Hedge Against Inflation:
Commodities, particularly precious metals like gold and silver, are often seen as a hedge against inflation. When inflation rises, the value of paper currency falls, but commodities tend to retain or increase in value. This makes them an important part of an investment strategy focused on preserving purchasing power during inflationary periods.

Example:
In countries like India, where inflation rates can be volatile, investing in gold as part of a diversified portfolio can protect investors from the eroding effects of inflation.

3. Supply and Demand Dynamics:
Commodities are influenced by the forces of supply and demand. When there’s a shortage of supply or increased demand for a commodity (e.g., oil, wheat), prices can spike. This creates opportunities for commodity investors to profit from price movements, which can be independent of equity market trends.

Example:
In 2020, the global oil price crash was due to a sharp decrease in demand, but in 2021, as economies began recovering from the pandemic, oil prices rebounded, offering investors attractive returns.

4. Global Economic Growth:
Commodities are often directly linked to global economic activity. For example, industrial metals like copper and aluminium perform well when global economies are growing, while agricultural products like corn and soybeans benefit from increased demand for food in developing countries. Including commodities in your portfolio can offer exposure to these growth-driven sectors.

How Commodities Fit Into a Portfolio:

1. Risk Reduction and Volatility:
Commodities often behave differently from stocks and bonds, reducing overall portfolio volatility. In times of market stress or economic downturn, commodities such as gold may perform better, helping offset losses in traditional asset classes.

2. Inflation Protection:
Commodities are one of the most effective tools for protecting portfolios from inflation. Since they generally rise in value when inflation increases, commodities can act as a hedge, especially for long-term investors.

3. Diversification Strategies:
Investors can achieve diversification by allocating a portion of their portfolio to commodities or by investing in commodity-focused ETFs or commodity mutual funds.

Example:
An investor with a primarily equity and bond-heavy portfolio could allocate 5-10% to commodities to enhance diversification and provide protection against inflation and market volatility.

In India especially, commodities like gold, silver, and agricultural products hold particular significance. Gold, in particular, is seen as a safe haven in times of market volatility or economic crisis. Indian investors have historically allocated a portion of their wealth in physical gold, but in recent years, gold ETFs and commodity mutual funds have provided a more liquid, cost-effective way to invest in gold and other commodities.

The Multi Commodity Exchange (MCX) is the primary exchange for trading commodities in India, and it offers futures contracts on a wide range of commodities, including precious metals, energy, and agricultural products. The rise of commodity-linked investment products, such as ETFs and index funds, has made it easier for retail investors to include commodities in their portfolios.

Commodities are an essential tool for portfolio diversification, offering protection against inflation and market volatility. By understanding how commodities behave relative to other asset classes, investors can make more informed decisions about integrating them into their portfolios. In the next chapter, we will dive into Gold Derivatives and Trading Strategies, one of the most popular commodity derivatives, and explore how to invest in gold using these tools.