Commodities Act I: What are they?
I'm personally a strategic asset allocation, buy-and-hold, re-balance quarterly type of investor. This makes me boring and not care about what is happening in the markets. It helps me sleep at night too. The downside is whenever I hear about commodity funds achieving huge returns while the stock market has lingered at the same value for 10 years, I ask myself should I look into this a little more?
So I've decided to dedicate a series of blogs about commodities. This first blog in the series is about a primer of what commodities are and why they are considered an investment.
In the Beginning.....
When humans began to establish permanent settlements centered around grain producing regions it started a revolution in basic economics. Grains provided people an ability to store present production for future consumption on a more efficient scale relative to hunting and gathering. This is revolution was basically driven by the science behind the grains' ability to store its nutritional value for periods much longer than meat from hunted prey.
This way of life had many benefits, but the main benefit was to hedge against unanticipated events in the future such as famine. Imagine how much higher the price of wheat could be if the granary was completely empty. In ancient societies this would be extreme famine conditions from a series of bad crop yields. On the flipside imagine how much lower wheat prices would be if the granary was filled to capacity.
The ability to store production resulted in ancient societies "investing" their present grain production in order to consume it at a future date. That is the essence of today's modern commodities market where non-farmers are "investing" in excess production of commodities to consume in the future. Except rather than physically taking possession of the commodities and storing them in a granary in our backyards, the current mechanism is through financial instruments.
Back to the Future
Based on this simple premise of buying commodities then consuming it in the future the benefit of "investing" in commodities is to hedge against unanticipated events in the future. In the modern society this event is called inflation.
By now you might have noticed and wondered why I have been using quotes each time I wrote "investing." The simple answer is "investing" in commodities is not "investing." At the very core of this financial instrument is the fact that it is not a real "investment." In economics investing represents a use of production factors to create an asset to further enhance other production factors.
For example, a company decides to use its resources to develop a scheduling software system to improve efficiency of its production crews. The use of the scheduling software system is a true investment since it enhances a production factor. In this case it was labor.
Commodities on the other hand does not enhance a production factor. Therefore commodities cannot be considered an investment.
Obviously "investing" in commodities provides a real benefit of hedging against unanticipated events. Famine in ancient societies and inflation in modern society. If the intent of the individual is to allocate personal resources to holding commodities to hedge against unanticipated inflation, then any allocation of resources greater than the person's future consumption of those commodities would be considered speculation.
In the next article I will try and blog about modern portfolio practices and commodities' rightful place as an asset class in anyone's portfolio.