I get worried when I start seeing signs that people think they can make a boatload of money with little work and no expertise. We can all remember the day-trading fad of the late ’90s, and more recently, the truly unfortunate notion that “flipping†real estate was a road to riches. Although commodity trading hasn’t quite reached that level, late-night commercials about cashing in on gold seem to be numerous, and banner ads about the promises of oil trading are commonplace. What’s most alarming is that this all seems like a familiar scene from a movie we just saw.
The two most visible commodities, oil and gold, are having eerie déjà -vu price spikes. It’s not just those two commodities, though. Between summer of 2010 and early 2011, coffee, corn, wheat, copper, and silver all rose between 64% and 256% before pulling back a bit.
You can find any number of reasons to explain these hot runs; the simplest explanation is the global growth story. Over the past several years emerging countries have been experiencing unprecedented growth. Businesses and governments in China, India, and elsewhere have been demanding metals, lumber, cement, and other materials like never before. Meanwhile, as billions of previously impoverished people enter the middle class they want the same goods that residents of developed countries have long enjoyed: more cotton clothes, orange juice and coffee at breakfast, and meat for dinner. This surging demand puts pressure on limited supplies, causing sharp price spikes.
Even so, putting money in commodities simply doesn’t pass my litmus test for sound investing. An investor who purchases a business, outright or through shares, does so because the cash flows returned should ultimately be worth more than the original capital invested. Similarly, when you invest in a bond, you eventually expect to be repaid your principal plus interest along the way. Commodities do not have cash flows, however, because in the
words of the great Warren Buffett, they “don’t do anything.†They don’t make interest payments, nor do they have profit margins. Here is what Buffett said about gold at the Berkshire Hathaway annual meeting this spring:If you take all of the gold in the world and put it into a cube, it will be a cube that’s about 67 feet on a side and 170,000 metric tons. You could get a ladder and get up on top of it and think you’re king of the world. You could fondle it, polish it … you could do all these things with it … but it doesn’t do anything. You’re hoping someone else in a year or five years will pay you for the thing.
When you buy a stock or a bond, its price in the marketplace reveals whether you’re likely to get a good return. With a commodity, you’re hoping to get one. That’s not good enough for me. My main point: Trying to get rich off commodities is a risky business indeed. Commodities can crater as quickly as they soar.
Although I don’t back them as an investment, they do tend to rise in inflationary environments so some financial experts advocate using them as an inflation hedge. For a financial expert, a hedge is a position taken to limit losses in a larger position. So an inflation hedge aims to preserve value when rising costs erode the purchasing power of each dollar.
Simply put, if your retirement portfolio is worth $500,000 and returns 5% per year, your purchasing power falls if inflation moves above 5%. Low-returning investments like cash and bonds therefore are hard hit. Stocks can lag a bit because companies’ costs for raw materials–metal, grains, petroleum–rise before they can increase prices. Meanwhile, of course, if you own those raw materials–commodities–they do well even as they hurt the rest of your portfolio. Taken all together, if inflation mounts, a small commodity position’s gains can help offset poor performance in bonds and even stocks.
Now inflation hedging is far from necessary for most people, but if you fear we’re verging on high inflation, here’s how to do it smartly. First, limit your investment to a single-digit percentage of your net worth. Second, use a broadly diversified portfolio designed to hold up well versus broadly rising prices–don’t simply “bet†on oil or gold. The experts at Morningstar consider Harbor Commodity Real Return Strategy Fund (HACMX), run by PIMCO’s Mihir Worah, to be the best such portfolio. Finally, rebalance from time to time to make sure your allocation doesn’t drift too low or become a larger portion of your portfolio.
Mellody Hobson is president of Ariel Investments L.L.C., a Chicago-based money management firm that serves individual investors and retirement plans through its no-load mutual funds. She is also a regular contributor to ABC’s Good Morning America.