What’s a Commodity

Commodities are the ignored stepchildren of the investment world. They don’t receive the constant media attention of stocks, bonds, and real estate. Most people understand the significance of the daily rise and fall of the stock market, but the impact of the commodity market is more vague.

As a useful definition, a commodity is an economic good or service that is interchangeable with other goods and services of the same type. This means that the quality of a given commodity may differ slightly, but it is essentially uniform across producers. Commodities are the raw resources that go into other products. Examples include wheat, iron, pork, gold, oil, and oranges.

The demand and price for a commodity are very close to being the same across all markets. That is because oil is oil, no matter where the well is. While there are different grades of oil, the same grades are almost identical wherever they come out of the ground. This differs from something manufactured, like a laptop. A product like this is different from one company to another and has so many different design possibilities that they all vary in price.

You can invest in commodities just as you do stocks and bonds. Like those other investments, commodities have their own markets. Investors access about 50 major commodity markets worldwide. Futures contracts are the traditional way of investing in commodities. You are purchasing an item like lemons or iron at a certain price. The market determines whether the price goes up or down on that item. It is the same concept as stocks, but without the same degree of volatility.

Like stocks and bonds, commodities can also be part of a fund. You buy a share of a fund, and its performance depends on how the commodities within the fund perform. To further get an idea of how commodities work, let’s look at three commodities that receive a lot of publicity and actively traded on the market.

Gold

Gold is the most popular of the precious metal commodities. Supply and demand drive the price of gold, as well as the demand created by speculation. The performance of gold bullion is often compared to stocks as an investment vehicle. Gold is regarded as a way of storing value (meaning no growth) while stocks have a return on value when you take into account the hope of a real price increase in the stock plus its dividends. Stocks and bonds are better investments in a stable political climate with little turmoil.

As with any commodity, the key with gold is knowing when to invest so you can take advantage of its appreciation. Of course, the counterpoint to that is selling before the price tumbles and reallocating your investment resources.

Oil

Investors can also directly invest in oil as a commodity. There are several ways to approach this. The easiest way for the average person to invest in oil is through stocks of oil drilling and service companies. Another method of owning oil is by purchasing oil futures or oil futures options. These are highly volatile and involve a great degree of risk. Additionally, investing in futures may require an investor to do a lot of research as well as invest large amounts of capital.

The volatility in investing in oil can be seen right here in the United States over the last half dozen years. When fracking became an economical method for extracting oil from shale, areas of the country boomed with renewed economic vigor as the oil industry expanded to areas never used for oil production before. Towns sprang up around these areas with a call for workers to travel to places like Texas or North Dakota. The amount of oil surged, as did profits. A few short years later, these areas became ghost towns and wells closed as the price of oil dropped and made those operations cost prohibitive. They could very well open again when the price of oil goes up.

Currencies

Money is a commodity, and actively traded as any grain or mineral. The foreign exchange market (Forex) trades in currencies. The way the currency market works is that if you think that the price of the dollar will drop in the future, you buy one or more currencies that you think will rise. There is a key difference to keep in mind between stocks and currencies.  Stocks move independently of each other while currencies move relative to each other. This means that when one currency is rising, another must be falling.

The average rate of return on commodities is about 6%.  Depending on the commodity, you can have natural disasters and man-made problems greatly affect your investment. However, if you look at the broad picture, commodity investment can certainly be a valuable component of any portfolio.

As with all investments, do your research or consult an investment professional before committing your money. You will find your comfort level with this investment as you spend more time determining what works for you.