The Difference between Commodities and Stocks:
Many people are not sure of the difference between commodities and stocks as investment options. In this article, we’ll go over the differences and similarities between the two forms of investments and how they relate to the individual investor and personal finance.
Commodities include a broad range of traded goods, but the basic definition is that they are goods or products designed for consumption. Common examples include gold, silver, corn, beef, orange juice, oil, and coffee. There are many more commodities categories including more exotic varieties (for example, you can even trade weather), but that’s the basic idea.
Commodities are traded as futures contracts. For example, if you wanted to invest in corn, you could purchase a contract from a farmer whose crop is currently growing. This contract would be for, say, 100 bushels of corn. The farmer sells the contract in order to lock in a price that he thinks is higher than what he would receive at harvest time. You would be purchasing the contract because you think that the price of corn will be higher at the time it is to be delivered. As owner of this contract, you have the right to sell it to whomever you want for whatever price you can get. The new holder would then own the rights to the farmer’s corn come time for the contract’s fulfillment. At the time specified in the contract, whoever is holding it will be delivered 100 bushels of corn by the farmer. Whether or not his crop came in, he is still under obligation to provide the bushels. Futures contracts are normally traded on large commodities exchanges around the world. The Chicago Mercantile Exchange is one such exchange.
Commodities can also be held by private investors as personal reserves. Among the most common methods of holding a personal reserve is for someone to have gold or silver bars in a safe location. If the price goes up, they can sell and make money; if the price decreases they lose money.
One of the main advantages of investing in commodities is protection from inflation. A bar of gold will always be a bar of gold. It doesn’t matter what governments do, or how markets move, you’ll always be able to melt it down into jewelry or computer components. The same idea goes with a barrel of oil or a bushel of corn. The value of money will never affect the use value of the commodity. The other great advantage is that if you have information pertinent to that good before anyone else, you can trade on it to your advantage. For example: if you know that a freak frost has hit Southeast Asia, you can reasonably assume that the price of rice will go up. If you have this knowledge before most other rice traders, you have the ability to buy low now and sell high later.
Disadvantages of investing in commodities also exist. The primary disadvantage is that commodities trading is a zero sum game. It is much like a game of poker where for every winner there is a looser and vice versa. Also, as in poker, the trader with the best information (usually the most up to date information), has a distinct advantage. This brings us to the “house-edge.” Many small traders believe that they can beat the market, but few have the same access to information as the large trading banks and financial corporations. We’re talking about companies that will pay tens of millions of dollars just to be one building closer to the exchange so that their trade orders will take a fraction of a second less to travel down the wires than their competition. Also, as with all investments, you have to pay to play. Usually this is in the form of fees, taxes, and commissions.
Stocks can be loosely defined as portions or “shares” of a company. Nowadays, they are usually created when a company wants raise money for expansion or to research and market new products. When you purchase a share of a company, you become part owner of that company. As an owner of part of the company, you can expect to receive some of the company’s profits. You’ll also likely share any of the company’s losses.
There are two ways that companies generally share profits with their shareholders. The first is by paying dividends. If a company makes money, it will send a dividend check for a portion of the money it has made to each shareholder with the money being split proportionally among the holders. For example: If company A declares a $1.00 per share dividend, then a person holding 10 shares will receive $10 and a person holding 50,000 shares will receive $50,000.
The other way that companies share their profits is by reinvesting them into their business. For example, instead of paying out the $100 million that a news company made last quarter to its shareholders, they can instead use that money to expand circulation, buy more trucks, or to buy more efficient printers. This increases the value of the brick-and-mortar portion of the business and thereby should increase the value of each portion or “share” that is in circulation.
Stocks are usually traded on large exchanges. Perhaps the most famous of these is the New York Stock Exchange on Wall Street in New York City. At these locations, brokers buy and sell shares of companies for their clients and it is there that the current stock prices are established by the economic laws of supply and demand.
One of the main advantages of owning stock in a company is that you are holding a portion of a (hopefully) income producing business. Stocks also tend to be protected against inflation because as the value of the dollar declines, the price of the brick-and-mortar holdings of the company will increase. Companies also have some, though not infinite, leeway in raising prices to match a falling dollar.
One of the main disadvantages of owning stocks is that they are subject to market volatility. For example, if everyone who owns shares of a company panics and sells their shares for whatever reason, the share price will plummet. It won’t matter if the company is a great income producer and has no debt, the street value of its shares will drop. The opposite can also happen when a company becomes hyped up and its price rises to levels that do not represent its earning potential (this was one of largest contributors to the Dot-Com bust of the late 1990’s). As in commodities trading, there are also fees, taxes, and commissions associated with trading and owning stocks.
So Which Market Should You Enter?
This is a personal decision and beyond the scope of this article, but before you enter any market be sure to continue your research into its inner workings. Many people are afraid of the wild fear and hope based swings of the stock market. They prefer to park their money in commodities. Others fear inflation and view stocks as a way to own a gold mine instead of a gold bar, or an oil company instead of a barrel of oil.
Whichever you choose, remember that the surest way to protect your investments is to diversify and practice buy and hold techniques to protect your investments from market swings. Practicing these two strategies should allow your commodities holdings to meet inflation over the long run and your stocks to ride out the possible wild market swings of the future. And, if both markets seem too risky for you, remember that there are always US savings bonds!