Are Commodities A Good & Safe Investment?

The question of whether commodities are a good investment has been banded around alot in the financial blogosphere lately. The second, more contentious question is whether commodities are a safe investment or not. Let me first distinguish between the two, and quickly explain why a safe investment isn’t necessarily a good investment, and why a good investment doesn’t have to be safe.

Why Safe Isn’t Always Best

In the financial markets, which encompasses banks, stock exchanges and just about all financial products, you are rewarded for risk. Many modern finance theories that you would study at university will show you that the market compensates risk.

The CAPM model states that the expected return of an investment is always equal to [the risk free rate + the market risk premium * risk of investment relative to market].

  1. Risk Free Rate = Yield on safe government bonds, so about 3%
  2. Market Risk Premium = Average return on stocks less the risk free return, so about 5%
  3. Risk of investment relative to market = 1 if your investments are as volatile as the average stock, above that if it’s more risky, and less e.g. 0.5 if the stock is less risky.

 

Therefore if you buy a stock that is about 1.5 times more volatile than the average stock, your expected return is = 3% + 5%*1.5 = 10.5%

You can see from this quick theory lesson that you will never be compensated for holding something that is ‘safe’ and unexposed to normal market risks. The risk free rate is all you can expect to receive if you capital is guaranteed and your income is guaranteed on an investment. This risk free rate is usually just enough to keep up with inflation, but will never produce significant real returns. If you want to see growth in your investment both nominally and in purchasing power, you will need to expose your investment to some risk.

Are Commodities A Safe Investment?

Lets define ‘safe’ in 3 ways:

  1. Safe means that the asset has a very low volatility.
  2. Safe means that the asset will protect your wealth from capital losses.
  3. Safe means that in a financial crisis, you will not lose money.

So how do commodities stack up against these 3 definitions?

Low Volatility

Unfortunately commodities utterly fail at volatility. In terms of day-to-day movements, they’re even worse than stocks. One paper shows commodities to be exceptionally volatile throughout history, and it’s not getting any better or worse. The myth that gold is a ‘safe’ investment is one of my Common Gold Myths and Shocking Mistakes Made By New Investors.

Protection From Capital Losses

With high volatility comes little protection of capital in the short, medium or even long term as many supporters say. An investor who invested in gold in 1980 will still not have recovered the purchasing power (ie the value of their investment adjusted upwards for inflation) by the current day (2011) despite the lofty highs that gold has recently been trading. On this basis, I believe that gold’s ability to hold value is heavily reliant upon the timing of the purchase. It certainly appears that gold will never be back in the sub $500 price range again, but to expect it to continue trading at $1,600 per troy ounce is unrealistic. As the past has shown, such gold prices are only achieved in times of uncertainty and when buyer speculation and gold-bug fever is high.

It’s always unhealthy to focus on just one commodity, so let me demonstrate with another. Cocoa, a relatively unpopular commodity that hasn’t been in the news much, serves as a good example.

Cocoa traded at $5,300 in 1980! That’s $13,838 in todays terms. In other words, someone who had invested in 1980 wouldn’t have even made half their real money back by now. I hope this example clearly demonstrates that cocoa etc are very vulnerable to commodities being overpriced. If commodities are overvalued now, then they certainly won’t be healthy for your capital.

Not Losing You Money in Crisis

Now this definition is the saving grace of commodities. While their value fluctuates very strongly and can cause great losses – they always keep their value in hard times. Why? Because everyone else believe they will too. When recessionary fears kick in, nervous investors move into the ‘safe havens’ of commodities. Also, speculators and smart investors also get in on the action because they understand this relationship is strong too. Taken together, this almost guarantees that commodities will do well in recessions and even depressions. This brings me back to why I think gold is overvalued. Rather than being on the brink of a recession, our global economy in 2011 is at a gateway where the future could be prosperous, but could be tougher than we first imagined. Which way the economy will go… nobody can say for sure, but are we in a safer place than 2008 when the financial system was on the brink of collapse? Definitely.

So why is gold even higher than in 2008? I believe that this is the bubble effect – investors moving money into this list of gold ETFs and indeed this list of silver ETFs to ‘chase gains’ and ensure they’re not missing out. Unfortunately they’ve forgotten the relationship between gold and economic recovery, and don’t realise what a perilous position they’ve put their investment in given that a global recovery is a strong possibility over the next 5 years.

Conclusion – Are Commodities Safe and Good Investments?

Is Investing in Commodities are good investment? I personally don’t believe they are, given that their valuation appears to be peaking again similar to 1980.

Are commodities a safe investment? On most definitions of the word “safe”, no they’re not. However adding some to your portfolio will help it during market crashes. Thus this ‘unsafe’ investment will ironically make your portfolio less risky.

Simon OatesAre Commodities A Good & Safe Investment?