{"id":470,"date":"2018-11-14T18:59:42","date_gmt":"2018-11-14T18:59:42","guid":{"rendered":"https:\/\/courses.lumenlearning.com\/suny-personalfinance\/?post_type=chapter&p=470"},"modified":"2019-01-18T14:37:11","modified_gmt":"2019-01-18T14:37:11","slug":"commodities","status":"publish","type":"chapter","link":"https:\/\/courses.lumenlearning.com\/suny-personalfinance\/chapter\/commodities\/","title":{"raw":"17.3 Commodities and Collectibles","rendered":"17.3 Commodities and Collectibles"},"content":{"raw":"
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Learning Objectives<\/h3>\r\n
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  1. Define and describe the characteristics and uses of derivative contracts.<\/li>\r\n \t
  2. Explain the roles of precious metals in an investment portfolio.<\/li>\r\n \t
  3. Describe the methods available to individual investors in making commodities investments.<\/li>\r\n \t
  4. Compare and contrast the advantages and disadvantages of using collectibles in an individual investment portfolio.<\/li>\r\n<\/ol>\r\n<\/div>\r\n<\/div>\r\n

    Some investors prefer to invest directly in the materials that are critical to an industry or market, rather than investing in the companies that use them. For example, if you think that the price of oil is going to rise, one way to profit from the higher price would be to buy shares of oil companies that profit by refining oil and selling gasoline, fuels, and other petroleum products. Another way is to buy the oil itself as a commodity.<\/p>\r\n

    Commodities are raw materials\u2014agricultural products, metals, energy sources, currencies, and so on\u2014that go into producing goods and services. Investing in commodities is a way to profit directly from the raw material rather than from its products. As discussed in Chapter 12 \"Investing\"<\/a>, commodities trading is not new\u2014the first commodities exchange in the United States was established in 1848.<\/p>\r\n

    Because they are or rely on natural resources, commodities have a largely unpredictable supply. They have inherent risk, because they are exposed to changes in weather or geology or global politics. Commodities trading began as a way for commodity producers and consumers to manage their risks. These traders are managing risks going forward; that is, they hedge by buying and selling commodities that they expect to exist in the future. This trading is done using future and forward contracts\u2014types of derivatives, discussed in the Chapter 12 \"Investing\"<\/a>.<\/p>\r\n

    Investing in commodities involves transaction costs and a time limit on realizing your gains (or losses), because derivatives are time-sensitive contracts created with an expiration date.<\/p>\r\n

    Commodity investing is risky business, because it is done through derivatives\u2014assets whose value depends on the value of another asset. For instance, the value of a contract to buy or sell soybeans at some time in the future depends on the value of the soybeans. When you invest in a derivative, you are taking on the risk of both contract and the asset that it depends on. One strategy to manage this risk is to invest in both, creating a situation in which one investment can act as a hedge for the other. The way this works is if the underlying asset (the soybeans) gains value, you\u2019ll lose on the derivative (the futures contract on soybeans); but if the asset loses value, you can gain on the derivative.<\/p>\r\n

    One example of this is the \u201cprebuy\u201d offer common in regions where homes are heated by oil. When you heat your home with oil, you are exposed to the risk of volatility in the price of oil. This volatility can upset your household budget and, since heat is a necessity, can take away from your other spending needs. You could guarantee your winter\u2019s cost of oil by buying it all in the summer, but you would need a huge oil tank to store all that oil until winter. As an alternative and to attract customers, some heating oil suppliers offer a prebuy deal. During the summer, customers can buy their winter\u2019s supply of oil at a set price, and the oil company will then deliver it as needed over the winter months.<\/p>\r\n

    If the price of oil goes up, the customer is protected and gains by not having to pay the higher price. The oil dealer loses the extra profit it could have had. On the other hand, if the price of oil goes down, the dealer is assured its profit, while the customer pays more than necessary without the prebuy deal.<\/p>\r\n

    In the language of commodities trading, the customer is \u201cshort\u201d oil, that is, needs it and seeks to lock in a price through the prebuy deal. The oil dealer is \u201clong\u201d oil, that is, has a supply and wants to sell it and so seeks to lock in the sale of a certain quantity at a certain price. The customer wants to lock in a low price, while the dealer wants to lock in a high price. Each is betting on what will be \u201clow\u201d and \u201chigh\u201d relative to what the real price of oil turns out to be in the future. The hedge of the prebuy deal relieves both the customer and the dealer of the uncertainty or risk. The deal creates its own risks, but if those are smaller than the risk of oil\u2019s price volatility, then the dealer will offer the prebuy, and the customer will take it.<\/p>\r\n

    When you trade commodities, you are also exposed to the risks of trading in the commodities markets. Another reason that commodities investing is risky for individual investors is because professional commodity investors often take speculative positions, betting on the future price of derivatives without holding investments in the underlying assets. Speculators can influence that future price, which after all is just the market\u2019s consensus of what that price \u201cshould\u201d be. For individual investors, the risks of commodities trading often outweigh the advantage of whatever diversification they bring to the portfolio.<\/p>\r\n\r\n

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    Gold, Silver, and Precious Metals<\/h2>\r\n

    Historically, gold and silver have been popular investments of individual investors. For thousands of years, gold and silver have been used as a basis for currency value, either minted into coins or used to back currency value. When a currency is backed by gold, for example, or is \u201con the gold standard,\u201d there should be a direct relationship between the value of the currency and the value of the gold.<\/p>\r\n

    In times of inflation or deflation, investors worry that the value or purchasing power of currency will change. They may invest in gold or silver as a more stable store of wealth than the currency that is supposed to represent the metal. In other words, if investors lose faith in the currency that represents the gold, they may trade their money for the gold.<\/p>\r\n

    Most currencies used today are not backed by a precious metal but by the productivity and soundness of the economy that issues them. For example, the value of the U.S. dollar is not related to the value of an ounce of gold, but to the value of the U.S. economy.<\/p>\r\n

    When economic or political turmoil seems to threaten the health of an economy and hence the value of its currency, some investors choose to invest in the gold or silver that seems to retain its value. For that reason, gold or silver has historically been regarded as a hedge against inflation.<\/p>\r\n

    How exactly do you buy gold? Gold bullion is sold as bars or wafers in units of one kilogram or 32.15 troy ounces. Metal dealers and some banks will sell bars or wafers ranging from 5 grams (or 0.16075 troy ounces) to 500 ounces or more. Transaction costs are relatively high, between 5 percent and 8 percent, and there is the cost of storing and securing the gold bars or wafers.<\/p>\r\n

    A more popular way to buy gold is as coins, which are more easily stored and secured. Gold coins are minted by several countries, including the United States, and may be bought from banks, brokers, and dealers for a fee of about 2 percent.<\/p>\r\n\r\n<\/div>\r\n

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    Commodity Indexes and Exchange-Traded Funds<\/h2>\r\n

    As with stocks, bonds, and real estate, the most popular way for individual investors to invest in any commodities\u2014including precious metals\u2014is through open-end mutual funds or exchange-traded funds (ETF). The fund may invest in a variety of contracts, diversifying its holdings of the commodity. It has professional managers who understand the pricing of such contracts and can research the market volatility and the global economy. Using a fund as a way of investing in commodities thus provides both diversification and expertise. It can also give you more liquidity as fund shares can be quickly traded into the market.<\/p>\r\n

    For example, if you expect inflation and want to buy gold, instead of trying to buy gold bars, you could invest in a fund (iShares), an exchange-traded fund (Comex Gold), or mutual funds (Fidelity Select Gold or Vanguard Precious Metals). These funds allow you to \u201cown\u201d gold but also to get diversification, expertise, and liquidity, reducing your risk.<\/p>\r\n

    There are mutual funds or exchange-traded funds for nearly every commodity that is traded. There are also passively managed commodity index funds, similar to stock or bond index funds. Investing in commodities can be a way to achieve asset diversification in your portfolio, because often a commodity such as gold is countercyclical to the economy, and therefore is countercyclical to your stock and bond holdings as well. Commodities may also add significant risk to a portfolio, however, so the advantage of adding them as a diversification strategy may be canceled out by the additional risk.<\/p>\r\n\r\n<\/div>\r\n

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    Collectibles and Unique Investments<\/h2>\r\n

    Any asset that is tradable may become an investment; that is, it may be purchased and held with the expectation that it can be sold when its value increases. So long as there is a market for it\u2014a buyer\u2014it potentially may be sold at a gain.<\/p>\r\n

    Collectibles and unique investments include the following:<\/p>\r\n\r\n