Why are commodities risky assets for investors?

December 15, 2009

Recently I received an email asking me to explain why commodities are risky assets. ”I would think energy and raw
materials would still be in demand, even if Dubai defaults,” the writer said.

 It’s a good point. People need to eat, drink, drive and live. They can’t do it without commodities.

 But for investors commodities are risky. That is because they mostly invest using commodity futures, which are subject to
wild price swings because they react strongly and immediately to demand and supply news and changing expectations for the future.    Since commodities became more popular with investors they have also become highly influenced by market sentiment and macro economic indicators and that’s why they have been moving alongside equities.

More investors in commodity futures markets is also why the link between equities and commodities has become much stronger over the past year to 18 months.

 But that’s an aside. Ultimately commodities are risky because they are volatile. Institutional investors don’t like volatility whether its price volatility or return volatility.

Comments

Well, another reason that commodities are inherently risky is that they are not interest earning assets. They cost money to store. The cost of carry.

Therefore, a long-only investor can only make a positive return if the price rises. If a bond fluctuates in price the holder still receives the coupon, and an implicit yield to maturity, unless they have to sell early at an inopportune time.

The same for stocks. At least for stocks that pay a dividend. But with commodities you literally have to buy low and sell high, or with futures sell high and buy low, to make a profit. And because there is a buyer and a seller at every price the chances of making a profit at any entry price is a slim 50/50.

The payout profile – that looks like a barbell – also adds to the return volatility if only half of all trades are profitable. Add in taking profit too soon, or leaving losses to run, the returns not only become worse, on average, but become asymmetrical.

Those that own storage and physical facilities, and can arbitrage both the cash and the futures market, can hedge their bets and improve their chances of capturing more of the aggregate profit over investors who can only buy or sell the futures. It is a true insiders game, so amateur investors start with a few strikes against them from the get go.

Posted by MrBill | Report as abusive
 

Dear Reuters, two days ago I spent considerable time forumulating a comment about commodity markets. I regret now that I did not save it as you have not published it either. It was definitely on-topic and not remotely offensive. It was based on my over twenty years of trading commodities. It would be better if you did not accept readers’ comments if you are not going to publish them. It is a waste of everyones’ time. Thank you.

Posted by MrBill | Report as abusive
 

Dear Writer,
Your views on this subject are quite relevant and are quite interesting for further analysis.
Yes. All essential things to be purchased, stored for day today needs are a must to any individual.
On other side, commodity future markets are risky and to be watched on current trends and some introspection towards it for proper handling and whether it will be fetch more profits at the time of delivery,prices are within our reachable levels and it should not bite our purses and should not face some criticisms from our family and from our self.
Good article for intelligent introspections for prospective buyers and to prospective sellers.

Posted by mdspatsy | Report as abusive
 

hi I have a silver eagle collection is it true that silver is so low that their not going to make silver eagle coins. do you know the word on this or some one who does please get back to me thnakyou

Posted by greenhunter | Report as abusive
 

thankyou

Posted by greenhunter | Report as abusive
 

When investing in commodities combine volatility and patience and risk is minimum. Paper losses on commodities become gains over time. Stocks are much more dangerous, tech stocks in particular or a more obvious example, Japanese stocks which still have not recovered from the lows of the early 90′s

Posted by tbernst | Report as abusive
 

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