Why commodities are a lousy inflation hedge.
If you've been listening to the Wall Street marketing machine, you have probably heard one of the popular market mantras of our day: buy commodities to protect against inflation. On the surface, this might sound like a reasonable idea. After all, commodities go into a lot of the things you and I use every day--gasoline, food, clothing, etc. Unfortunately, commodities make a lousy inflation hedge and can actually increase the risk of an investor's portfolio without increasing the return.
What is a hedge?
Investors hedge portfolios in an attempt to protect them from undesired risks. A hedge protects the investor by producing gains that offset losses in the underlying portfolio. The net effect of the hedge is to reduce the variation in the portfolio's return. To the extent the portfolio experiences losses without offsetting hedge gains, volatility in the portfolio will not be reduced and the hedge is said to be ineffective.
Since a properly-hedged portfolio is supposed to produce less variation in returns, we can test the effectiveness of various hedges by comparing the volatility their portfolio returns.