Wikinvest Wire

An optimal stocks/commodities investment portfolio

Thursday, April 24, 2008

This is a follow-up to the post the other day about a study by Professor Craig Israelsen at BYU showing how adding commodities to an investment portfolio not only boosted gains but reduced overall volatility.

At the time I noted:

The returns get even better if you favor the asset class(es) that happen to be in a secular bull market and reduce your exposure to the one(s) in a secular bear market.
Craig was kind enough to send me the raw asset class performance data for the purpose of answering the question asked of myself, "What would overall returns be if you were 100 percent in commodities during secular bull markets in commodities and 100 percent in stocks during secular bull markets in stocks?"

The answer is shown below and the timing is somewhat surprising - it is far better to be too early than too late when switching from one to the other.
The chart shows the performance of an investment portfolio that started out at $10,000 in 1970 fully invested in commodities using the Goldman Sachs Commodity Index (GSCI) as the benchmark.

Sometime around 1980, as the secular bull market in commodities was ending, the portfolio would be switched from commodities to stocks using the S&P500 index as the benchmark. Then, sometime around 2000, another switch would occur from stocks back to commodities.

The first thing that should be clear from the chart is that, whenever the switch occurred, the results are far better than a "stocks-only" or "commodities-only" approach which both have average annual returns in the low-teens.

Average annual returns for the commodities-stocks-commodities portfolio are in the high teens, going as high as 20 percent for the best two cases, which, over this long a period of time makes the $10,000 investment worth millions instead of hundreds of thousands of dollars.

The other important point in the chart above is that it's better to be early than late in making the switch. The best overall performance was achieved when switching after 1978 and 1998 (violet curve) or after 1979 and 1999 (orange curve).

The latter change makes a lot of sense since oil and gold both peaked and fell in 1980 and stocks peaked and fell in 2000, but the 1978-1998 switch is less intuitive.

Overall, the data shows what was expected - that secular bull and bear markets have a tremendous impact on long-term gains and that, generally speaking, you're not doing yourself any favors by ignoring commodities as an asset class.

One last note. This sort of an investment approach is certainly not one that would be easy to stick with once adopted. More than anything else, this data was assembled to prove a point - that commodities are an important part of a good investment portfolio.

There are few investors who would be able to survive a 100 percent exposure to commodities during their down years within secular bull markets - consecutive losses of 17 percent and 12 percent in the mid-1970s and a 32 percent loss in 2001 would be difficult to endure.

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