We are constantly talking about the importance of diversification in your portfolio because good diversification can actually increase your returns and at the same time, lower risk. How is that possible you may ask, when normally, higher returns bring with them higher risk? It’s due to the fact that effective diversification is achieved by including asset classes in your portfolio that have low correlation to one another.

The correlation between two investments measures how closely the prices of the two investments move in tandem with each other. If two types of investments have high correlation, their prices will move up and down together. With low correlation, their price movements are unrelated. If they are strongly negatively correlated, they will move in opposite directions.

Investments that have low correlation tend to achieve their highs and lows at different times. Thus, some will be down in bad markets while others may be up in value.

It turns out that commodities (oil, precious metals, corn, soybeans, etc.) exhibit low correlation to many of the traditional asset classes people own in their portfolios (stocks and bonds). Because they have low correlation, adding commodities to your investment portfolio can improve your portfolio’s diversification. As noted above, improving diversification can increase your portfolio’s return and lower its risk (volatility).

In addition, many investment advisors believe that commodities are a good hedge against inflation. At the present, inflation is quite low and many economists expect it to remain that way in the near term. Others, however, worry that our high national debt will lead to high inflation in the long run. Including a small amount of commodities in your portfolio can help protect you from increasing prices.

We all know that our natural resources are limited. As we use more and more of them and they become scarcer, their prices will rise dramatically. This is another reason to consider owning commodities. The problem is, there are limited ways to invest in commodities and commodity prices can be very volatile. If you are interested in investing in commodities, we highly recommend that you seek professional advice on the best way to invest. We’ll talk more about ways to invest in commodities in the future.