Commodities and Your Financial Plan
Before I started my journey as a CERTIFIED FINANCIAL PLANNER™, I would watch the daily stock tickers and be amazed at the price increase of certain commodities. In particular, I was convinced I could make money on a barrel of orange juice, big ole bag of coffee, a few pig skins(because American’s love football). My fascination turned to disappointment and subsequent nightmares when I learned how commodities actually work.
As a financial coach and financial advisor representative, I enjoy continuing the conversations about different basic investment terms and how they apply to everyone. In fact, I've started a small series of articles about these terms, what they are, and how to easily comprehend and understand them. If you're interested in catching up on some of these, be sure to check out the latest one I put out, ETFs and Your Financial Plan. However, I've also released articles about Mutual Funds, Bonds, and Stocks.
In all of these articles, as I will in this one, I explain these financial terms and break them down into easily digestible bites that answer some of their most asked questions. Today's article will be very much like this, with one notable exception. Things like mutual funds, stocks, and bonds all operate within a sort of an abstract space. Today, we'll be talking about commodities, which are much less abstract and more physical/concrete!
While I don't work with commodities, I still think it's very important to know what they are and some of the dangers behind investing in them. In fact, I've always had this nightmare about purchasing a contract for commodities only to forget about it and have a dump truck worth of a product delivered to my front door on the expiration date. While this may sound like a wild fever dream, it's actually a genuine concern and situation that one might find themselves in if they aren't careful about investing in commodities! So, without further ado, let's dive in and find out more about commodities, what they are, how they work, and some of the risks involved with them.
Commodity is somewhat of a catch-all term. It encompasses many things like precious metals, raw materials, chemicals, and raw food like wheat or corn. Many non-business owners who buy contracts and invest in commodities do so to create diversity in their portfolio. This is because commodities tend to move in different, opposing ways than stocks or bonds. This alternating of risk theoretically makes the whole of your portfolio less risky. In other words, if the stock market dips, the commodity market may do well and vice versa. Investing in both could mean that you're never losing too much money at one time.
Types of Commodities
What classifies as a commodity is a broad spectrum of things. As I said before, a commodity is usually something like a raw material, but it can be many things! There are four main categories of commodities, which almost all commodities fit into. The four types of commodities are metals, livestock and meat, energy, and agriculture.
Metals are our first commodities category! The metals category of commodities refers to precious metals. Metals that are included in this category are copper, platinum, gold, and silver. These metals are typically bought to be used in manufacturing as well as metals that fall into this category are often purchased as an insurance plan of sorts which shields their investors from the dangers of a volatile monetary system in times of economic downturn. In other words, investing in precious metals is a way to solidify your wealth in a way that doesn't rely on a country's currency, which is thought to protect the investor from hyper-inflationary events.
Livestock and Meat
Livestock and meat commodities are just what they sound like. There isn't really too much more to go into detail about here other than people just need to eat and livestock and meat farming is one way that commodities help accomplish that.
The energy sector is a very important one. Its commodity market is created of crude oil, gasoline, electricity, wind, solar, etc. While the energy commodity type has been around for a long time, it's been the recipient of much criticism and change in recent years. Classic forms of energy production methods like oil and coal are expected to be turbulent in the near future as policy pushes and changes are paving the way for new forms of energy production methods like wind and solar.
The last primary type of commodity is agriculture, which is far-reaching. Many think of agriculture as simply food and raw food items like corn and wheat. However, agriculture also includes things like cotton, which may be used for clothing.
There are various ways for one to participate in trading commodities, but one of the most common is through the use of Futures Contracts. NerdWallet defines futures contracts as "an agreement to buy or sell an asset on or before future date at an agreed-upon price… Typically, futures contracts trade on an exchange; one party agrees to buy a given quantity of securities or a commodity, and take delivery on a certain date. The selling party to the contract agrees to provide it."
Investors and speculators who buy into futures contracts typically don't do so to buy or sell a product. Instead, they are interested in the contract, which has the potential to make them money. For example, if one purchases a commodities future contract in which the buyer and seller agree to make an exchange of cotton at $2.00/LB, but the price of cotton rises, the purchaser of the futures contract stands to make money reselling the agreement.
Risks of Commodities
Remember what old uncle Ben from Spiderman said, "With great rewards, come great risks." Okay, well, that might not actually be the quote. To be honest, I haven't watched Spiderman recently, but I'm sure it goes something like that. All joking aside, there really are significant risks to be taken in the commodities market. While it's easy to sound all like fun and games buying, selling, exchanging commodities and their contracts - there is an inherent risk along with a tremendous monetary risk should anything go awry.
An extreme example of risks in commodities is Tulip Mania. I wrote about this semi-recently in my post about investment bubbles. Essentially, this was an era of time when Tulips were thought to be extremely valuable, and investors bought into astronomical tulip futures contracts, only for their market to crash. While this is an extreme example, it highlights how speculating on the future of a commodity could quickly turn out poorly for those hedging bets.
Let's face it, the majority of commodities exchanging is speculation. Whether you're purchasing precious metals to protect yourself against economic doom or purchasing energy contracts in hopes that their price will rise. The main thing to remember about speculation is that it's done without absolute knowledge, which is inherently risky. To make it even more dangerous, commodities are an investment type that is historically volatile, meaning their price could quickly go up or down. So, while the potential rise in the price of a commodity could stand to make you quite a bit of money, the potential downside is also essential to be considered.
Commodities in Action
Commodity trading can make a huge difference to major business that rely on various commodities for everyday business. Price saving strategies can make or break businesses.
One of my favorite examples is the jet fuel futures trading that Southwest Airlines had put into place in the early 90s. Since 1998, it has saved $3.5 billion over what it would have spent if it had paid the average market price for jet fuel. That's equal to about 83% of the company's profits over the last 9½ years! It’s a fascinating story that you can read about… here.
A CERTIFIED FINANCIAL PLANNER™ Can Help You Create a Customized Financial Plan
Like I said in the beginning, commodities aren't something that I work with. However, if you're interested in diversifying your investment portfolio, creating wealth, and or saving for the future, please, feel free to call or email to schedule an appointment with me. Together, we can create a financial plan that helps you avoid bubble investments and generate wealth for you and your family, perhaps over a glass of orange juice!
Until next time...this is Melissa Making Cents!
Melissa Anne Cox, CERTIFIED FINANCIAL PLANNER™, is also a College Planning and Student Loan Advisor and Financial Coach in Dallas, Texas.