Investing 101: Commodities

(Ah, Tuesday, that most impressive day of the week.  Known for coming after Monday, being the day before trash day in my neighborhood, and of course, a new Investing 101 column here on the Amateur Financier!  At times I wonder just how many Investing 101 columns I can keep producing until I exhaust all the investment opportunities available to the average investor, but I then I look at the sheer number of possible investment avenues, and I have to conclude that this column (or something similar) could be sustained almost indefinitely.  With all of that said, it's time to learn more about commodities!)

Q: I know I always start out by asking this, but what are commodities?

A: Commodities, in brief, are the raw materials that businesses and people use in the course of producing goods for sales.  Pretty much any physical object can be considered a commodity.  In practice, the most commonly traded commodities fall into a few main categories: energy sources (like oil, natural gas, and coal), metals (from industrially important metals like aluminum and copper to precious metals like gold, silver, and platinum) and agricultural products (corn, wheat, and cattle, among others).

Q: Alright, why should I invest in commodities?

A: There are a few reasons to invest in commodities.  First, since they are used in a variety of industrial and other business processes, they have an underlying worth, which keeps them from falling in value to nothing, unlike stocks or bonds.  Second, commodities, unlike many types of investments, tend to hold up well under inflationary conditions, which many people fear will soon be upon us when the economy picks up.  And finally, they can provide diversification to a portfolio, as commodity investments tend to move out of tandem with many other investment classes.

Q: Sounds good!  So, should I just go out and buy up a bunch of commodities, then?

A: It's not quite that simple.  While it's possible to purchase and hold some commodities in your house or a safe deposit box (for example, gold or silver bars), for others, buying and holding the commodities directly isn't always possible for the average investor.  Unless you happen to live on a farm (or have a very understanding spouse), you are unlikely to be able to keep a few hundred head of cattle on your property.

Q: Um, okay then; how could I invest in commodities?

A: There are at least three ways to break into commodities:

Futures: One of the major ways to invest in commodities is through futures contracts.  If you want to invest directly in commodities without buying and physically holding them, futures are the easiest method.  However, futures can be risky, and if you aren't absolutely sure about what you are doing, you can lose a great deal of money, potentially even more than you initially invested.  (One way around this risk is to invest in a commodity pool, sort of a mutual fund for futures, where individual allow the pool operator to put their money together and buy futures for the pool.  This arrangement allows easier diversification, and frequently limits the potential loss to just the invested money.)

Stocks: A more indirect method of investing in commodities is to hold stock in companies that produce the commodities.  If you wanted to benefit from rising oil prices, for example, you could buy Exxon stock.  The correlation between the stock price and the commodity might not be perfect, however, and there are other concerns about the underlying company that you need to understand, as with any direct stock investment.  Proceed with all due caution.

Mutual Funds/ETFs: These could be invested either in futures or in the stocks of commodity linked companies (typically in sector specific funds).  While they might be a little bit harder to find than typical funds, they do provide one of the easiest and least worrisome ways of expanding your commodity exposure as well as ensuring diversification.

That's it for this addition of Investing 101; I hope you know have a little better idea of what exactly people are talking about when they discuss commodities and commodity investing.  It's an interesting area, one that will affect you regardless of your job or investment choices (as anyone who lived through four dollar a gallon gas last year could tell you), and it's good to understand how the market for them works.

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