Many people will tell you to stay away from risky investments. But if you follow that advice, there is a chance that you might throw out the baby with the bathwater.
Think of risky investments like you think about salt: Too much could eventually kill you, but too little can be bad in other ways.
The same is true for assets like gold, industrial metals, grains, or even art. A little can be a good thing. Go overboard with it and you’ll probably go bust.
What not to do. One way to break the bank is to take your entire net worth and then use it to purchase commodity futures contracts on margin. Margin is the name given to the practice of borrowing part of cost of the investment.
“Do that and you might as well as blow it all on red at the casino,” says Victor Sperandeo, a registered commodity trading advisor at EAM Partners in Dallas.
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Futures trading requires only a tiny percentage of the value of the contract to be deposited. That increased leverage and means that small price movements in the futures market can make a trader a lot of money. Or alternatively it can lose the same person a lot, possibly more than originally invested.
Like Sperandeo says, you wouldn’t take your inheritance to the casino or the race track either. So don’t bet the farm on commodities.
But overblown concerns about such behavior being repeated by small investors means many designers of 401(k) retirement plans refuse to allow their participants the choice of alternative asset classes like commodities.
Just because company bureaucrats are overly cautious doesn’t mean you can’t do it right for yourself in an individual retirement account.
Volatile, but not necessarily inflammable. “There are some commodities that are more volatile than the S&P 500 index,” Sperandeo says. “But you can use commodities in a very conservative way.”
The key is diversification. It’s been an accepted principle among investors that overall risk can be reduced by combining asset classes that perform in different ways into a larger portfolio. The volatility of the prices of the different components of a portfolio even each other out over time. When all the pluses and minuses of the different classes are canceled out there tends to be less overall volatility.
Sperandeo suggests allocating 8 percent of a portfolio to a basket of commodities, a portion which is not out of line with what many other strategists suggest. Doing so has gotten him good returns and lower overall volatility. Volatility is how portfolio managers and other finance experts measure risk. Lower volatility equals lower risk.
“The point is that how you use futures, including gold, how much you allocate, and what you use in your constructed portfolio, determines how it will perform,” he says.
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Don’t look too close. The key to making such a portfolio work isn’t so much in designing one. A financial planner should easily be able to assist in that. But rather it’s in how you resist acting on your likely natural emotional response when prices of the commodities complex move sharply, as they are wont to do.
“The question is, are you willing to handle the big swings for that portion of the portfolio?” says Richard Rosso, partner at Clarity Financial in Houston.
He says the commodities portion will typically be the “wild child,” and investors “will need emotional stamina to handle the gyrations.”
Better still, look at the portfolio as a whole rather than each part in an isolated way. For two decades between 1980 and 2000 gold was a lousy investment, but stocks were great.
“But gold worked when the S&P 500 didn’t,” says John Dowd, portfolio manager of the Fidelity Select Natural Resources Portfolio (ticker: FNARX). During the so-called lost decade from January 2000 onwards, the stock market fell while gold shot up from less than $300 a troy ounce to more than $1,000 at the end of 2009.
Again, it’s not about looking at the performance of the component parts but the overall impact.
How to invest. There are a variety of ways to invest in commodities including directly in the futures market. However, for most smaller investors it may be easier to look at preconstructed portfolios via exchange-traded funds.
For instance, the PowerShares DB Commodity Index Tracking Fund (DBC), which tracks a broad basket of commodities, has annual expenses of 0.85 percent or $85 per $10,000 invested.
Likewise, the iShares S&P GSCI Commodity-Indexed Trust (GSG) also tracks a broad basket of commodity prices, and has annual expenses of 0.75 percent, or $75 per $10,000 invested.
Alternatively, there are funds which specialize in individual commodities like the SPDR Gold Shares (GLD) or the iShares Silver Trust (SLV), and many others. The problem with single-commodity funds for many individual investors is getting a balance of different commodities that reflects the over all commodities sector. Doing so might mean purchasing many different ETFs.
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The preferred approach of many is to keep it simple, and buy just one fund in an appropriate dollar size to fit in a bigger portfolio.
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Yes, Risky Investments Have a Place in a Portfolio originally appeared on usnews.com
