Want to Invest in Commodities? Be a Proactive Economist

For the most part, economists are not good at making predictions -- even as a crowd. They're often asked to make short-term predictions about their macro ("big picture")-economic research, which is a fundamentally difficult task. So why should you "be an economist" to invest in commodities ?

Because when it comes to your portfolio, we're discussing long-term investments, not short-term ones.

Another good hat to wear, when investing in commodities: behavioral psychologist. Why? Because no less important than understanding economic factors and trends, is the ability to understand how people and markets react to them.

As with all investments, there are two distinct ways to invest in commodities: for the short term or for the long term. Trading in commodities for the short term is pretty much gambling, which I don't recommend as an investment approach, but some find it profitable (and enjoyable). The only time you are not gambling is when you are doing an arbitrage , which is buying below current market value , and not buying below "future" market value, which is often mistakenly called arbitrage as well. Hedge funds make these market moves all the time, but they use a lot of resources to be able to do so.

So the question is: How do you invest in commodities for the long term?

In the context of commodities, the "long term" might not be as long as you would think. In "Why Mixing Bonds and CDs With Stocks Actually Increases Your Risk," I talked about 20 to 30 years as the "long" term. With commodities -- depending on the specific commodity -- long term can be three to five years.

Three to Five Years?!

Commodities, such as oil and corn, are affected by business cycles and economic trends. This is similar to how currencies like the U.S. dollar, the euro or the Japanese yen are affected by their countries' respective economic cycles, as well as other geopolitical factors.

An energy company, such as Exxon Mobil (XOM Quote) (an "oil play"), or a company benefiting from higher demand for corn, such as DuPont (DD Quote) (a "fertilizer play"), can hedge its bets in the relevant sector and benefit whether prices go up or down, or sustain lower profits in a "down" cycle, knowing it would make huge profits in the "upturn."

You, on the other hand, cannot really hedge in the same way that an Exxon Mobil or a DuPont can.

Therefore, you have to understand economic trends, both local and global. If you understand these, you are on the first step to making money from commodities. But it is only the first step, however, because the market's reaction and your reaction to those trends are critical.

Unfortunately, we are poor at evaluating and acting on trends. Here's why: it takes several data points to understand a trend exists. Of course, you could "see it" coming if you analyze underlying factors, but that would make you an economist, right?

As I teach my students, there are two ways to forecast. The first is by "the numbers" or "the technicals" (Wall Street lingo: see quantitative analysis and technical analysis ). While you can benefit tremendously by using this method and exploiting consistent patterns, it only allows you to react to existing patterns.

The second method -- the economist's one -- is to understand how underlying factors affect prices. While more complicated, and requiring more data and fundamental understanding, it allows you to be proactive, and therefore exploit trends before the "crowd"can.

A Look (Back) at Oil

Three years ago it was already clear that oil prices would start to go up. Clear how? Recall the relatively fixed supply (refineries' capacity being the real bottleneck) and increasing global demand due to the rapid industrialization and growth of China, India and other emerging markets.

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