Finding the fungibility in commodities

Finding the fungibility in commodities

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Depending on your level of investing savvy, you may or may not be comfortable with the term ‘commodities’. As our global systems currently enter one of the toughest times experienced in over a hundred years, you may hear this term bandied about a fair amount.

Essentially, commodities are the basic building blocks of the global economy, upon which most other goods are created. They fall into two broad categories – hard and soft.

Hard commodities are natural resources that must be mined or extracted. These include energies such as oil and natural gas, and metals such as gold and aluminium. Soft commodities, on the other hand, are agricultural products such as crops and livestock.

When it comes to investment strategies, commodities and stocks often move in opposite directions to one another. Hence, commodities can offer a good opportunity to diversify an investment portfolio — either for the long-term, or during unusually volatile periods.

Commodities are essentially uniform across producers, and this uniformity is referred to as ‘fungibility’. For example, oil would be considered a commodity, but Old Khaki’s jeans would not be, as consumers would consider them to be different from jeans sold by other stores. When traded on an exchange, a commodity must meet specific standards, which is known as a basis grade.

A commodity market is a virtual or physical marketplace that is dedicated to the buying, selling and trading of raw or primary products. There are currently about 50 major commodity markets in the world that facilitate trade in approximately 100 primary commodities.

Over the past few years, the definition of ‘commodities’ has expanded to also include financial products such as foreign currencies, indexes and exchange-traded funds (ETFs). Technological advances have also led to new types of commodities, such as mobile phone minutes and bandwidth, being exchanged.

Commodities can have a big effect on investment portfolios. Basic economic principles of supply and demand tend to drive commodities markets, so lower supply increases demand, which equals higher prices (and vice versa). For example, a major disruption, such as a health scare among cattle, might lead to a spike in the generally stable demand for livestock.

Slumping commodity prices can also provide opportunities for investors. However, investing in commodities can easily become risky because they can be affected by eventualities that are difficult to predict, such as weather patterns, epidemics, natural disasters, and even politics. As a result, it is important to carefully consider your risk appetite and the length of time you have until you wish to achieve your goals, as this will affect the recommended allocation of your portfolio to commodities.

As with all elements of your portfolio, it is important to ensure you have a solid understanding of what you have allocated and why. Don’t be afraid to ask questions if you’re ever unsure of any terminology.