Hard assets have been one of the most significant asset classes over the last decade. From all indications, it will continue to be a critically important investment category to protect your portfolio from the effects of inflation and the continuing devaluation of the U.S. dollar.

Creating a gone-fishing portfolio begins with a top-level asset allocation. For a typical 40-year-old investor, the percentage in hard asset stock investments would be 17.0%.

Diversifying your portfolio will help lower your risk and increase your returns. One of the asset classes we use to achieve that goal consists of hard asset stocks. These hard asset investments include companies that own and produce an underlying natural resource. Examples of these natural resources include oil, natural gas, precious metals (particularly gold and silver); base metals such as copper and nickel; and other resources such as diamonds, coal, lumber and even water. We recommend broadly diversifying your hard asset stocks by resource type, by geographic location of a company’s reserves and by company size.

Investing in hard asset stocks is not the same as investing directly in commodities. Buying gold bullion or a gold futures contract is an investment directly in raw commodities or their volatility. Buying a gold mining company, in contrast, is a hard asset stock investment.

The S&P North American Natural Resources Index tracks hard assets. It consists of 62% energy and 15% metals and mining. These top-10 stocks represent about 43% of its holdings: Chevron, Exxon Mobil, Schlumberger, ConocoPhillips, Occidental Petroleum, Suncor, Freeport-McMoRan Copper, Apache, Barrick Gold and Halliburton.

We segment hard asset stocks like these into their own asset class because they have a unique set of characteristics. First, the movement of hard asset stocks is generally less correlated with the movement of other asset classes such as bonds. Second, hard assets have a unique (and positive) reaction to inflationary pressures. And third, at certain periods in the longer term economic cycle, including hard assets helps boost returns.

As of the end of May 2011, this index was up 12.76% year-to-date compared with the S&P 500’s 5.92%. Its five-year annualized return is 9.72% compared with the S&P 500’s 2.62. Beating the S&P 500 by more than 7% for the past five years is just one of the benefits of investing in this index.

The beauty of hard asset stocks is that they are not highly correlated to other categories. Most importantly, the correlation between the S&P North American Natural Resources Index and the Lehman Aggregate Bond Index over the past year was -0.28. A negative correlation means that the bond asset class and the natural resources asset class are often moving in opposite directions. Balancing a bond portfolio with hard asset stocks can help hedge the risk that inflation poses to a bond portfolio.

Over time, dollars lose their buying power and the goods and services we buy cost more. As an asset class, commodities generally maintain their buying power in dollar terms. Stocks as an asset class generally appreciate over inflation after dividends are factored in. And over the past decade, hard asset stocks have been appreciating nicely.

Because of inflation, cash, normally a safe store of value, has been the riskiest investment since 2002 when the U.S. dollar began losing much of its purchasing power. Since then, the U.S. Dollar Index has dropped more than 37%, from 120 to 74.7. It has also dropped more than 76% against gold as gold appreciated from 360 to 1536. The dollar has even dropped 37% against the euro as the euro appreciated from 0.90 to 1.43.

During inflationary times, U.S. bonds are not a safe store of value either. They pay a fixed rate of return in diminishing dollars. But a little bit of hard asset stock helps balance the fixed-income portion of your portfolio.

The simplest allocation to hard assets would put 100% of your hard asset allocation in the iShares S&P North American Natural Resources Sector Index ETF (IGE) that tracks this index. It has a low expense ratio of 0.48% and represents more than 150 holdings.

A slightly more sophisticated hard asset allocation might put 60% in IGE, 30% in Vanguard REIT Index ETF (VNQ) and the last 10% in the iShares S&P Global Materials Sector Index ETF (MXI). If your allocation to hard assets was 17%, this would result in investing 10.2% in IGE, 5.1% in VNQ and 1.7% in MXI.

VNQ seeks to track the performance of the MSCI US REIT Index. It has an extremely low expense ratio of 0.12%, and its correlation to IGE was a relatively low 0.66 over the past year. It has more than 100 holdings. It was up 28.5% last year and is up an additional 14.1% year-to-date. Vanguard’s new fund, VNQI, tracks the foreign REIT index. We are considering adding this as well into the mix of hard assets.

MXI seeks to track the performance of the S&P Global Materials Index. Its correlation to IGE over the past year was a relatively low 0.78. It includes foreign mining companies such as Australia’s BHP Billiton and Rio Tinto, Brazil’s Vale, Germany’s BASF, Canada’s Potash Corp and the United Kingdom’s Anglo American. The expense ratio is only 0.48%, and holdings number more than 120.

These two holdings should broaden your allocation to hard assets by including more REITs and mining and therefore provide additional rebalancing bonuses.

The purpose of a gone-fishing portfolio is to set a simple allocation for each asset class so you have time to visit some of these countries and enjoy the fishing. Include a hard asset stock allocation and rebalance each year.

Photo by Megan Marotta