At a recent investment meeting a discussing came up around the need to include Commodities in a portfolio and what percentage is required to shore up a portfolio in case inflation takes off or we encounter another market correction. Keep in mind that Commodities, as an asset class, is considered an inflation protector. David Swensen, author of Unconventional Success, includes TIPs (TIP) and real estate (VNQ and RWX) to be excellent inflation protectors.
In many of the ITA portfolios, where Commodities (DBC) and Gold (GLD) are two of the asset classes, the percentage allocations vary from 3% to 5%. Will these small percentages provide sufficient diversification? Low correlated asset classes or securities representing those assets provide a “draw-down break” to a portfolio when bear markets show up. At least that is the general idea investors predict.
In the following example, I want to apply some mathematics to this argument.
- The portfolio is $100,000 in size.
- In this example I will use a draw-down of 15% for the portfolio. In other words, an ETF such as VTI drops 15%.
- Commodities are inversely correlation. This is an exaggerated assumption used to prove a point. In some of our latest correlations runs, DBC has a correlation with the market (VTI) of something closer to 0.50 rather than -1.0.
- We assume the allocation to Commodities is 3%.
The argument to be tested is the following. Is an allocation of 3% to Commodities (DBC) sufficient to provide the “draw-down break” we are looking for? Granted, most portfolios hold other securities with low correlations that will also help to cut the overall draw-down, but for this argument we will concentrate on the 3% holding in Commodities.
If the market were to drop 15%, then a $100,000 portfolio dips to $85,000. This assumes we are not diversified into Commodities. How is this $100,000 protected if the market drops 15%, but we hold 3% in Commodities as a diversifier?
Ninety seven percent of the portfolio is in the broad market and 3% in Commodities.
$100,000 x 0.97 x 0.85 = $82,450 97% of a $100,000 portfolios experiencing a 15% drop in the market ends up with $82,450. Now we check to see how well a 3% holding in Commodities that gains 15% reduces this loss.
$100,000 x 0.03 x 1.15 = $3450. 3% of a $100,000 portfolio experiencing a 15% rise ends up with a $3450 profit. Keep in mind that Commodities are not inversely correlated. I used the -1.0 correlation to show the best results.
$82,450 + $3450 = $85,900. Instead of dropping to $85,000 without diversification, a 3% holding in Commodities provides a $900 cushion or very little protection. If one were to use the actual correlation (closer to 0.5) for Commodities instead of -1.0, the situation would be a wash.
Conclusion: If one wishes to diversify by holding low correlated asset classes, the percentage needs to be higher than 3%. This means I need to carefully examine the asset allocation percentages of the ITA portfolios as many are holding percentages of 3% to 5% in various asset classes and these percentages are too small to make an impact on the portfolio. I recommend a minimum holding in any asset class to be at least 5%.