Commodities and the Loss Aversion

Abstract

Commodity investment has become a popular asset class from the beginning of the 2000s because of their diversification characteristics. Their returns usually have low or negative correlation with the returns of traditional financial assets. This study extended the boundary of researches in commodity investment by applying the Prospect Theory in to the study. The theory suggests that investors are loss-averse. They view gains and losses differently and they are risk averse to the gain and risk seeking in the loss. In this paper, optimal portfolios were estimated for the loss-averse investor according to the Prospect Theory with respect to different degrees of loss aversion. Full-scale optimization allows the author to examine the proportion of portfolio that should be invested in commodities to maximize expected utility. Then, optimal portfolios with commodities were compared to the optimal portfolios that contain only traditional assets to see whether the investment in commodities can enhance portfolio performance. The findings indicated that commodities were attractive among loss-averse investors during the economic downturns and inflationary period. In financial market crisis, investors see commodities as a hedge against inflation and switch their investment from stocks and bonds to commodities with an expectation that the price of commodities increase with inflation. Although all types of commodities in this study become a significant part of the optimal portfolio during inflationary periods, futures contract on gold and physical gold investment are the two types of commodities that maximize optimal portfolio performance when added to the portfolio.