What Are Commodities?
First of all, let’s talk about the nuts and bolts of commodities as an investment. These are among the oldest type of investments in our financial marketplace, and the trade of commodities grew out of the need by both producers and consumers of various goods to reduce price risk into the future. It could be a farmer hoping to nail down a price for his crop in advance, or a convenience store chain locking in a price for gasoline… the idea is to reduce risk of volatility in prices when either the need to consume is ripe, or when the product is ready to be delivered. This is accomplished at a cost to the producer and/or consumer – known as a risk premium – that allows the buyer (or seller) at the other end of the transaction a potential profit benefit for taking on the risk.
Put simply: if a farmer has a potential 10,000 bushels of grain that will be available for delivery in three months, he seeks to lock in a price for his grain that represents a profit against his expenses. He sells his grain in the future (actually purchases an option to sell) at a specified price. The seller of the option has taken on the risk that the price of grain will be lower at that point in time (when the contract matures), since he is in essence taking responsibility for that grain when it is delivered. On the other hand, if the price of the grain at the time of the contract maturity is higher, the option seller stands to make a profit from the transaction. (It should be noted that the seller of the contract makes a certain amount, the risk premium, either way – but if the current price of the commodity is considerably lower at maturity of the contract, he’d still lose money on the deal.)
It works similarly on the consumption end – continuing our example of the grain above: if a bakery wants to lock in the cost of grain to make flour three months in advance, he might enter into a contract to buy grain at a certain price. (Keep in mind, the price that the farmer sells the grain and the price that the bakery buys the grain will not be equal – hence the risk premium.) The seller of the grain (could be the same guy) takes on a risk that the price of the grain at delivery is higher than the contract price, while vice-versa, would stand to make a profit should the price of the grain come in lower than the contract price at delivery.
Of course, the real world isn’t as simple as my example – because that guy who sold the options to the farmer and the baker? He’s likely to change his mind about how prudent those choices were when he made them, and look to find someone else to take on the contracts. He might sell them for less than he got for them (if he believes that the end result would be worse!) or he might envision a higher value for his option contracts (and get it) if the market will bear his selling at a higher price. And so it goes…
Note – I know that there is bound to be a commodities-trading guru out there who’ll look at my explanation and say “that’s pretty dadgum oversimplified” but the spirit of the concept is correct enough for this article, so calm down, would ya?
Why Do We Include Commodities In Our Portfolios?
Wait a second, we’re not quite ready to answer that question – first a word about correlation… no, wait – how about some examples of various commodities first, then correlation?
Examples of Various Commodities
There are lots of different commodities, but some of the major ones are:
- Crude oil
- Natural gas
- Live cattle
- Pork bellies
- Frozen Concentrated Orange Juice (FCOJ*)
The reason that we have more than one type of asset class in our portfolio in the first place is to diversify. And in order to be diversified, our various asset classes must not mirror rises and falls in the values of the other asset classes in our portfolio. This “not mirroring” is known as non-correlation – in other words, if two investments (or asset classes) always go up and down in similar proportions at the same time they are said to be correlated. If, however, when one investment or asset class goes up the other asset class either stays the same, goes down, or goes up but not at the same ratio, the two classes are exhibiting non-correlated behavior.
Of course by sheer happenstance there will be times when both assets move up in the same ratio as one another, but if we studied them over long periods of time we’d see the degree of correlation that they have to one another. If the two asset classes always move the same way in the same amounts they would have a correlation ratio of 1. If they always move in opposite directions in the same amounts, the correlation ratio is -1. Anything in between those two would be represented by a decimal (either positive or negative), expressing the degree to which the two asset classes were correlated. If the two show no relationship whatsover to one another, correlation is said to be zero.
Are We Ready to Answer the Question Now?
Yes, now we’re ready. In case you forgot, the question was “Why do we include commodities in our portfolio?” The answer is that commodities have, over significant periods of time (and shorter-terms in case you’re wondering) displayed a negative correlation to the stock market – both US domestic and foriegn – while at the same time maintaining a positive correlation to inflation.
What this means is that when we have investments in both equity (stock) and commodities, we can expect to have a portion of our portfolio on the increase any time the other portion of our portfolio is decreasing. Sounds like the best of both worlds, right? This is the benefit of diversification in action. We can add commodities to a portfolio quite simply, by using a mutual fund or exchange-traded fund (ETF) that follows a commodity index.
Now, obviously we wouldn’t just have the two asset classes in a portfolio, although you could do much worse, I suppose. No, in general our portfolio should include both domestic and global equities, including emerging markets, plus a portion of fixed income (generally domestic, government and global), along with commodities, real estate (domestic and foreign) and timber. Varying the proportions of these asset classes is how we increase our risk and therefore our potential for reward. We’ll talk about Timber as an asset class next month.