What Are Commodities and Should I Own Them?

by Hank Coleman

With everyone looking to get rich quick lately, there has been a huge push to find extra ways to squeeze out more and more percentage points from our investing rates of return. Commodities are a favorite talking point and investment ply of professionals who try and get the average investor to put their money in exotic investments. A commodity is a type of good for which there is a demand. A lot of people associate the term with a raw material or products that are traded strictly in commodities markets such as corn, gold, wheat, soybeans, coffee, oil, pork barrels, grains, and other metals. There are many different commodities that are traded on a daily basis.

Their Origins. Commodities markets have gained importance over the years. They started off as a meeting place for farmers and industrialists to arrange the exchange of the harvested produce in a standardized way. One of the first commodities markets is the Chicago Mercantile Exchange which bears the responsibility of having built many traditions and concepts still applied in these markets worldwide. Some of the many commodities that are traded include agricultural products, livestock and meat, energy products, precious metals, industry metals, and environmental commodities. The Chicago Mercantile Exchange (CME) is the leading American financial and commodity derivative exchange based in Chicago. The CME was founded in 1898 as the Chicago Butter and Egg Board.

Forwards and Futures Markets. An important feature of the commodities market is the ability to buy a forwards and futures contracts. The futures contract means that you can buy a certain commodity at a future date on a price decided today. This helps investors hedge against increase in prices as the demand for a certain good increases seasonally. For example, you see airlines that purchase future contracts for their jet fuel in order to lock in the current rates and hedge against price hikes in the short term. It also helps producers as they are hedged against a seasonal fall in demand. Further, futures contracts can be traded in a secondary market with prices changing with the spot (current) price of a commodity.

The Markets. Commodities markets are markets where commodities are exchanged to be held or sold to someone else in an organized manner. The exchange arranges the transactions in standard quantities and fixes the price of those units according to the market demand and supply. There are many controversies surrounding commodities as an investment instrument.

Commodity Prices. Some argue that commodity prices decline in the long run and hence are not an asset class. Over the last century, spot commodity prices have fallen by some 1.5% a year. The time horizons of most investments, however, are much shorter than 100 years. In recent times commodities prices took off like a rocket in early 2001 following a minimal price return performance for one decade. Prospective investors who went against investing in commodities missed out on this spectacular run-up in price.

So, the question remains, should you invest in commodities?  Maybe….

After Everything Else. You should only contemplate investing in commodities, futures, and forwards after you have maxed out your retirement accounts, children’s college funds, etc. and paid off all of your debts except the mortgage. You should max out your Roth IRA and contribute heavily to your 401-k retirement plan before you consider investing in a risky and exotic investment such as commodities.

Small Percentage. If you are ready to broaden your investment portfolio, consider investing only a small portion of your total nest egg in commodities. For most people, you should not invest more than 5% to 10% of your total investment portfolio in commodities, precious metals, real estate investment trusts (REITs), etc.

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