Commodity prices can go up, and they can go down. But while volatility is an expected part of investing, the volatility associated with commodities in particular makes this asset class a poor investment for most investors. That’s true whether they’re held in physical form (gold coins) or through vehicles like exchange-traded funds (ETFs).

Commodities are fundamentally different from investments like stocks and bonds. Stocks and bonds are financial assets, representing ownership or debt of businesses, respectively, whereas commodities are typically raw materials, such as oil, gold, copper, and corn.

Commodities’ values are based on their usage as inputs in production; if the production process or global demand for production changes, commodity values change. Financial assets, on the other hand, grow in value because they increase the amount of wealth available in the world through efficiency and innovation.

A position in commodities is a bet on getting lucky in the short-term future , while an investment in financial assets is a bet on long-term growth.

investing in commodities

The Ups and Downs of Commodities

Investors historically used commodities, especially gold, as a hedge against the risk of change, especially inflation or chaos. In the early ages of civilization, gold was used as a store of value—as money—because its limited supply meant that a little could be used to buy a lot, and because government-issued money wasn’t stable. Gold is the best naturally occurring element to become a currency—it’s durable, rare, malleable, and easy to purify, for little cost. If you were looking for a portable currency substitute, gold was it.

But things are a little different today. Gold and other precious metals still derive their value from durability and scarcity; other commodities, such as livestock, energy, and agriculture, derive their value from price shifts related to supply and demand.

There are various drawbacks to owning commodities that their admirers are inclined to ignore: the cost of ownership and storage (paying a vault to hold your gold), loss of value (crops going bad), chance of a better substitute being found (copper), or management costs (negative roll yield, transportation, and transaction costs). In short, commodities have reliable volatility with unreliable return. Once these risks are factored in, they aren’t attractive investments.

Those who prize commodities often highlight their physicality, making commodities more ‘real’ than financial assets. However, there’s an inherent irony in that distinction: The paper contracts that stock and bond traders exchange have more intrinsic worth as investments than the typical commodity.

The paper contracts that stock and bond traders exchange have more intrinsic worth as investments than the typical commodity.

The value of a financial asset can be expressed in relation to a company’s expected distribution of earnings, whether as dividends to shareholders or as coupon payments to bondholders. Stock and bond prices can deviate from those intrinsic values based on supply and demand, but prices tend to be anchored to company and economic growth and revert to it in the long run. Commodities, on the other hand, are just inputs to production or consumption. There is no cash flow expected from them until they are sold, and that price depends entirely on supply and demand at that time. Thus, there is more inherent risk in assigning them a fair future value.

Commodity fans also like to point to their independence from government-backed currency. True, but last time I checked we are still using government-backed currency in nearly every other aspect of life. And that’s unlikely to change soon.

How Commodities Really Work

Commodity prices are determined by supply and demand of producers, which, in turn, can be informed by economic developments and other factors, such as the macro-economy, politics, the weather etc. As to the true value of a commodity, it’s really whatever a final user is willing to pay for it. By buying commodities, you are just getting in between suppliers and producers, and driving up the price of commodities in the process.

Commodities vs. Equities

Indexed values from January 1973 to January 2015

commodities-equities-1973-2015-02

Commodities are certainly valuable—try driving your car or eating at a restaurant without them—but they don’t create wealth directly, so their value is really just a matter of sentiment and short-term supply and demand dynamics. While it is possible to purchase and hold a stock or bond and live on its earnings, the same is not true of commodities.

Perhaps more important, not only do commodities produce no income while held, but investors typically must pay storage costs, even indirectly when they take ownership through one of the numerous exchange-traded products that specialize in metals or energy or agricultural commodities.

Over time, we expect commodity prices—at least the commodities we talk about today—to fall in real terms as substitutes are found or processes are made more efficient. For example, from 1980 to 1990, the prices of five key metals (copper, chromium, nickel, tin, and tungsten) all dropped by 50%—a price change made famous by a bet between economist Julian Simon and biologist Paul Ehrlich.  The wager was that the scarcity of key commodities would change as technology and demand changed over a decade. Simon was right, and he still is today.

Why Commodities Are Not Good for Hedging

Some investors might think that the added expense and foregone income are small prices to pay if they’re going to get additional portfolio diversification and hedge against inflation or worse. But that’s a big ‘if.’ It turns out that commodities and commodity funds don’t expand the mix of a portfolio all that much and don’t provide as great a hedge as many think. Why?

  1. They are, by definition, narrow in scope.
  2. They are better than cash at beating inflation—but worse than stocks and bonds.
  3. They are risky.

Let’s go through these points one by one.

First, funds that follow broad commodity indexes aren’t all that broad: The indexes are heavily weighted to oil in recognition of its dominant industrial and economic role. There are single-commodity funds and notes—such as for copper, wheat, and cocoa—but by definition they provide exposure to a very narrow segment of the investment universe, one that’s probably too narrow for modest portfolios.

Second, for all the differences between commodities and stocks, both can safeguard investors against inflation. That can be seen clearly in data on very long-term returns for major asset classes compiled by Jeremy Siegel, a professor of finance at the Wharton School of the University of Pennsylvania and the author of Stocks for the Long Run.

From 1802 to 2013, gold had an annual real return, adjusted for inflation, of 0.6%, so technically it ‘worked’ as a hedge by increasing in value even after inflation is factored in. A dollar stuffed in your mattress suffered an annual real loss of 1.4% over the same period.

So, you would have been better off holding gold than dollars, but you would have been far better off holding almost anything other than dollars. Treasury bills produced an annual real return of 2.7%, Treasury bonds returned 3.5%, and stocks did best of all, producing an annual real gain of 6.7%.

Comparison of annual real returns (1802 to 2013)

Asset Real return, adjusted for inflation
Cash -1.4%
Gold 0.6%
Treasury bills 2.7%
Treasury bonds 3.5%
Stocks 6.7%

Source: Stocks for the Long Run

What about the role of gold as a hedge against chaos? That might seem useful if you’re in places like Ukraine and the Middle East, but Siegel’s research shows otherwise for developed nations. While the price of gold often spikes during a crisis, the meager returns through two eventful centuries allude to a pleasant reality: crises are brief, and the developed world isn’t such a bad place in the long run. That’s something that investors should remember as they build portfolios for the long run.

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