Most of us average josephine investors couldn’t tell you the difference between a hot commodity and a coconut. Actually, TECHNICALLY a coconut is a commodity, although not exactly a hot one. No wonder it’s sometimes hard to know the difference.
A commodity is simply a physical, interchangeable good that someone, somewhere wants to buy or sell. The most commonly mentioned commodities are gold, silver, oil, natural gas, wheat, corn, soybean (for some reason), and coffee (for obvious reason).
Some form of a commodities market has been around for centuries, since farmers have been trotting to market to sell their goods. Those farmers eventually realized that by the time they got to market with their bushels of wheat, they didn’t have much control over the sales price. If it had been a bumper year and every Joe Schmoe was selling wheat, the price might not cover the cost of the planting months earlier. So the farmers got clever. They started selling that wheat before it was planted. Not knowing what price they would get for their crops months later, they created futures contracts with willing buyers before they even planted that wheat and corn. The buyer was betting the price of the crop would be higher once it arrived at market and the farmer was betting it might be lower. Therefore, the buyer locked in a “bargain” and the seller locked in a “windfall”. Pretty nifty, huh?
So, why do many investors avoid investing in something that sounds so simple? Because it’s risky. You are buying something that doesn’t exist yet or selling something you might not be able to deliver. And the financial techies have taken those futures contracts out of the hands of the farmers and made them a lot more complicated.
But even if you don’t own a pair of overalls or need a big bushel of wheat in your kitchen, you should still consider commodities for A PIECE of your overall investment portfolio.
Why? Because commodities act differently than stocks and bonds. When inflation is low or stable, stocks and bonds look attractive. But when inflation is rising, the price of commodities (remember, physical goods everyone needs?) is going up. Thus, with commodities you are creating some downside protection in your portfolio.
Certain commodities are all over the news right now. Gold is over $1,000 per ounce; oil hit $75 per barrel yesterday. “Are they overpriced or is this a long-term bull run?” One could argue that with the basic need for oil, metals and food in the emerging markets of China and India, the rise in commodities is here to stay. And did I mention that every time the US dollar declines, commodities trade higher? That’s because those same emerging countries can now buy those US goods cheaper. Commodities are definitely looking good.
This does not mean, by the way, that you should rush out and buy some gold bullion. Or bushels of wheat, for that matter. Not all commodities do equally well or poorly at the same time. Nor does this mean you should shift out of stocks and bonds in the hope that commodities will make up for past losses. I would argue that a 10-15% maximum allocation for most investors is enough to get the diversification you need from commodities.
Moreover, for every bullish commodities trader there is one clamoring that the commodities market is overheated right now. Sound familiar? And, unless you want to start doing some active commodities trading, your best bet is to leave the guesswork to the experts.
So, how do you obtain an allocation of commodities in your portfolio?
1. Invest in a commodities-focused mutual fund. The rule of thumb is that the fund should have exposure across all four different types of commodities (energy, precious metals, industrial metals and food).
2. Invest in a commodities ETF. Again, diversification is key, even if you need 4 different ETFs to get there.
3. Buy stock in commodities-related companies, such as oil companies, gold-miners, natural gas producers, food processors.
4. Dip your toe in the futures markets. Not my first choice for most investors. Make sure you know what you are doing and how futures work.
5. Grow your own corn and take it to the farmer’s market. You will not get rich with this approach.
Want to read more about commodities? Jim Rogers is the guru of commodity investing and he wrote all about in his 2007 book,
Hot Commodities: How Anyone Can Invest Profitably in the World’s Best Market by Jim Rogers.
Still not sure if commodities are right for your portfolio? Then stay tuned – next week I’ll talk about Real Estate.
Photo by: yomi yomi