by Ed Cliff
Incorporating commodities to a asset portfolio may help in diversifying your account while at the same time providing the various other advantage of inflationary defense. Each individual investor appreciates how efficient it could be to get a well-diversified portfolio. When a portfolio is properly diversified, certain securities will increase under certain circumstances, while other securities tumble under the same conditions. The understanding of diversification is to locate non-correlated securities which will go up and down in value at various moments. An investor does not want "all their eggs in just one basket" (highly linked securities) since there is the opportunity to lose everything abruptly.
The right diversification will help to protect against many risks in the market place. These dangers are known as diversifiable, or unsystematic risk. When one company in your portfolio suffers from a firm-specific occurrence say for example a court action, labor strike, or regulatory action that negatively affects their competitive advantage, that circumstance won't radically affect a well-diversified stock portfolio.
Nevertheless, there are a few risks that can't be diversified away. These are call non-diversifiable, or systematic risks. Systematic risks are the type that affect the entire economy. These range from natural disasters, wars, governmental events, among others. Generally these scenarios can be difficult to calculate, and may have bothersome affects on a well-diversified portfolio.
One kind of systematic risk that could be imagined, and can be hedged against, is inflationary risk. This may be the risk that the profit on your investment strategies will probably be decayed by climbing inflation. As inflation soars, your buying power reduces, i.e. your money you have does not buy as many goods or services. If you have a long-term investment that returns 10%, but inflation increases 5%, in which case you only received 5% on the investment over that time period (in inflation adjusted terms).
So how does inflationary risk influence your portfolio, and exactlty what can you do to secure your savings within a time period when inflation is booming? If you have a portfolio composed entirely of futures, then you should be alright. Company revenues and profits usually increase at around the same pace as inflation, since corporations simply increase their prices to balance out their growing costs. Companies that carry massive cash reserves, similar to Microsoft, have a tendency to get hit harder by rising prices as they lose purchasing power on their cash holdings. By studying a company's financial statements, it's possible to generally anticipate how a company is going to be troubled by inflation.
Inflation will hit an investor who maintains fixed-income securities, for example bonds, very hard. If you buy a 20-year bond yielding 10% for $1,000, then you expect you'll receive $1,100 in 2 decades, thus earning 10% on the investment. On the other hand, if inflation goes up 7% in those Two decades, then you certainly actually only earned a 3% inflation-adjusted return on your investment.
If you're investing in a period of "stagflation" then you may need to be a lot more wise with your investments than during times of conventional inflation. Stagflation occurs when prices are increasing, but the overall economy is not expanding. As an example, 2012 is expected to be a year of stagflation. Nations everywhere have gathered significant amounts of financial debt. As these countries have to take up austerity measures in order to stay solvent, global economic growth with fall for many years in the future. At the same time, the large influx of money in the global markets (from central banks simply slinging money at debt issues) is effectively increasing the prices of products and services. All of this shows a textbook example of stagflation. Stagflation affects bonds roughly exactly the same way as regular inflation, as purchasing power minimizes with overall price increases. However, stagflation has a adverse effect on stock values. When an economic system is struggling to grow, demand for products or services are likely to remain low. When need is low and prices are high, organizations are taking on increased costs for working, but are failing to increase revenues and earnings. Thus, a company's profit margins will probably be negatively affected by stagflation, and their stock price will drop.
As a way to protect against inflation and stagflation, a savvy individual will add commodities to their account. Commodities are a great addition since they're frequently not highly correlated along with other assets, so they convey a level of diversification. Additionally, commodities have a tendency to surge in price when inflation rises. So, commodities will hedge against the side effects of price increases inside an account.
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