Oil & Gas and Commodities--Do They Add Any Value to an Retirement Portfolio?

[Bailing-Bob]

I am on my second reading of ESR-Bobs's book Live More-Work Less. I am giving serious consideration to his 16 asset class Rational Investors portfolio, except I do not intend to invest in the hedge funds or private equity. The other asset classes that I am on fence on are Oil & Gas (3%) and Commodities (4%). I am just not sure if those funds really dampen or increase the volatility of the portfolio in those low doses. If I were to include Oil & Gas and Commodities in my portfolio should I apply different re-balancing rules to those asset classes. My rule is to re-balance once per year. The Oil & Gas and Commodities classes are so volatile, I am wondering if I should apply a rebalance rule based on a certain percentage deviation from the target allocation. How do you typically address the rebalancing of extremely volatile asset classes such as Commodities and Energy? How much do those classes really add to return? Do you really believe they dampen volatility? Or are they just extra protection against inflation?

 

[mb]

A year or so ago (after much of the run up ) I started looking at natural resource funds.

IIRC, the TRP fund that I bought had a long term return (5 or 10 year) within a percentage point of so of the SP500 but had a correlation coefficient of about 0.3.

I decided to invest because of the low correlation coefficient and my opinions on peak oil.

I've been DCAing into it since then. It's still a small % of the total portfolio so I haven't worried about balancing.

MB

 

[magellan_nh]

The Oil & Gas and Commodities classes are so volatile, I am wondering if I should apply a rebalance rule based on a certain percentage deviation from the target allocation. How do you typically address the rebalancing of extremely volatile asset classes such as Commodities and Energy?

I apply a percentage deviation approach when I rebalance all asset classes. I usually use around a 5% deviation from the target amount as a trigger.

It would be nice for rebalancing to be a strictly mechanical process, but practical issues like trading costs, taxes, and the fact that our portfolio is split into retirement and non-retirement accounts get in way and require the use of a fudge-factor.

How much do those classes really add to return? Do you really believe they dampen volatility? Or are they just extra protection against inflation?

I think these asset classes probably take away from return overall. Over long periods of time, I'd expect them to appreciate at about the same rate of inflation, with a potential bonus in cases where supplies get tighter against growing worldwide demand.

In my mind, commodities don't provide a real "growth" component, just the hope of volatility reduction when integrated into an otherwise balanced portfolio. For me, that hope is enough to include them in the allocation mix.

I use REITS, Commodities, and Gold as sub-classes in a "hard assets" asset class that I allocate about 12% to. To me, REITs are the only sub-class that have a real growth potential. Gold and commodities (and energy too if you add that) are just there to dampen volatility.

Not sure if the wisdom in this plan, but that's what I do. Time will tell.

Jim

 

[Nords]

I'm a little perplexed when people take a system developed through years of study or billions of computing hours, generally validated by the math or by peer review, and say "That's the system for me! But I don't believe that their research is completely correct..."

If you're tweaking a recommended portfolio for the purpose of experiential learning then tweak away. But if you're tweaking out of some expectation of improving it then you ought to let Bob know that you're ready to collaborate on the next edition of his book.

I am wondering if I should apply a rebalance rule based on a certain percentage deviation from the target allocation. How do you typically address the rebalancing of extremely volatile asset classes such as Commodities and Energy? How much do those classes really add to return? Do you really believe they dampen volatility? Or are they just extra protection against inflation?

I think rebalancing on asset allocation (out of whack by a certain amount) boosts portfolio returns more than rebalancing by the calendar. (That's what the research is showing.) Calendar rebalancing is like DCA-- it's not the best way to invest your money but it's a disciplined system that people can easily follow. The benefits come from the discipline, not the timing or the math.

Excess volatility generally leads to lower returns. However you don't care how volatilie commodities & energy are on their own-- you care about how they reduce your portfolio's overall volatility. If your portfolio is less volatile then you're hypothetically sleeping better at night. But if you're not comfortable with the excess volatility in an asset class that's a very very small part of your portfolio, then perhaps it's better to reduce portfolio volatility in some other way-- like a bigger allocation to some other less-correlated asset like bonds.

But the important issue here is to distinguish math from "sleep at night" comfort. Either is a valid investment method but they shouldn't be confused with each other. The math says that commodities reduce overall portfolio volatility. So if that's what you want then that's what you should do. But if their individual volatility keeps you from sleeping soundly, then it's highly likely that you're going to screw it up by bailing at the first excessively downward price blip.

I'm not sure how commodities protect against inflation. If you want inflation protection, it'd seem to be a lot easier to buy I bonds or TIPS.

 

[Spanky]

The math says that commodities reduce overall portfolio volatility. So if that's what you want then that's what you should do. But if their individual volatility keeps you from sleeping soundly, then it's highly likely that you're going to screw it up by bailing at the first excessively downward price blip.

Holding PCRIX (commodities fund) has kept me pondering on whether to drop or to add more to bring it back to its allocation percentage, albeit it is small.

 

[cute fuzzy bunny]

Commodities protect against inflation because they generally are among the basic building blocks of the things that cause inflation. Basic food items, energy, etc. In fact, their price swings tend to predict inflation rather than tips or ibonds who are priced to a measurement of the resulting effects.

I suspect things like oil futures, commodities and whatnot were better diversifiers before everyone made note of that and jumped on the bandwagon. When theres a selection of etf's and mutual funds on a particular asset class that you used to have to buy individually through a more complex effort, its possible that a little wind has been taken from the sails...

Plus now that everyones jumped in, the prices have gone up. I dont see too many bargains.

But then our dear departed Ted, well known for telling prospective moms and dads to go to planned parenthood because the world was overpopulated with morons like them, IIRC made a lot of his money buying oil futures contracts.

Ah yes... http://early-retirement.org/forums/index.php?topic=110.0

 

[magellan_nh]

I'm a little perplexed when people take a system developed through years of study or billions of computing hours, generally validated by the math or by peer review, and say "That's the system for me! But I don't believe that their research is completely correct..."

If you're tweaking a recommended portfolio for the purpose of experiential learning then tweak away. But if you're tweaking out of some expectation of improving it then you ought to let Bob know that you're ready to collaborate on the next edition of his book.

I hear you Nords, but private equity and hedge funds? I'm surprised he didn't throw in timber for good measure!!!

IMHO, the problem is that investors and investment researchers run in a herd and right now private equity and hedge funds are all the rage. Who knows, they may pass the test of time. However, if you jump right in and add every fad asset class to your portfolio as soon as it gets hot, your portfolio will get very messy over time.

Personally, I think it's very reasonable to use your own personal judgment in deciding when an asset class is "time tested" enough to add to the mix. There's no such thing as Moses on the mount in this business. One stop shopping asset allocations are great for beginners, but I think investors willing to do some research and apply good judgment can do better.

BTW, I'm not saying we should ignore the talking heads. Each time new research is published, I like to dive right in and find out if it helps my understanding of things in ways that I can integrate into my own plan.

Jim

 

[Jarhead*]

Nords: Realize that your question is rhetorical, and how they'll perform in a slightly more than "polite" inflation is a good question.

But one thing I know for sure, is the best inflation protection in the robust inflation that we had in the late 60's through the 70's was best handled by being "short". (I remember getting a 16% 4 year CD in the late 70's, and thinking to myself, O.K., but I went a little long.)

CD,s and Money-Markets were close to keeping up with inflation, but they beat the hell out of stocks and bonds that were by and large, flat or down.

Ask Ha, he'll tell you.