If you read a mutual fund prospectus, or a hedge fund’s exposure, the odds are that it will supply you, among other information, with some quantitative summary claiming to measure “risk”. That measure will be based on one of the above buzzwords that derive from the bell curve and its kin.

Such measures of future uncertainty satisfy our ingrained desire to “simplify” by squeezing into one single number matters that are too rich to be described by it. In addition, they cater to psychological biases and our tendency to understate uncertainty in order to provide an illusion of understanding the world.

The bell curve has been presented as “normal” for almost two centuries, despite its flaws being obvious to any practitioner with empirical sense. Granted, it has been tinkered with, using such methods as complementary “jumps”, stress testing, regime switching or the elaborate methods known as GARCH, but while they represent a good effort, they fail to address the bell curve’s fundamental flaws.

The problem is that measures of uncertainty using the bell curve simply disregard the possibility of sharp jumps or discontinuities and, therefore, have no meaning or consequence. Using them is like focusing on the grass and missing out on the (gigantic) trees. In fact, while the occasional and unpredictable large deviations are rare, they cannot be dismissed as “outliers” because, cumulatively, their impact in the long term is so dramatic.”

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The real surprise, however, is that commodity futures returns had a lower standard deviation (lower risk) than stock returns for the 43 years they studied. This study also confirmed that commodity futures work best when needed most in a portfolio. This is mainly because stock and bond returns are negatively influenced by inflation, where commodity futures benefit from inflation. In other words, during periods of inflation or expected inflation, stock and bond returns underperform commodity returns.

Anyway you look at it; these reports legitimize commodities and challenge the “too risky” myths that have been adopted over time. Perhaps all the stories of lost assets can be attributed to two risky behaviors of investing, unacceptable leverage and poor risk management. However, these risky behaviors have nothing to do with the core properties of commodity futures.

To receive the full Yale School of Management’s report, “Facts and Fantasies about Commodity Futures”, click here to email me and enter “Yale” as the subject. The report will be sent in a PDF format.

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