Investing in Commodities: Five Lessons from the California Gold Rush

When it comes to investing our money, history and memory do not often serve us well. So as the price of gold breaks records (see "Randgold CEO: Gold to Top $1,200 in 2008" on TheStreet.com TV), here are five investing lessons from the famous California "gold rush" of 1848, applied to today's hot commodities markets.

1. When many rush to find 'gold,' a few make a lot of money but most lose. This is the basic rule of bubbles. During California's gold rush, most gold diggers joined late in the game. The majority ended up wasting lots of resources and money, but not finding much gold.

Similarly, most who invest in a hot commodity (such as gold) do so just before it cools off, and therefore lose money. The relatively few who do make money are the ones who have the prescience to invest before the hot trend is evident in "the numbers" (see "Want to Invest in Commodities? Be a Proactive Economist").

It is not just psychology at play here, but a basic economic rule: for prices to go up, demand has to be higher than supply. Without that, a commodity wouldn't be considered "hot."

Therefore, one of the basic rules of investing applies: buy a commodity when few want to buy it, and sell when many want to buy it.

The exception to this rule is discussed in Want to Invest in Commodities? Be a Proactive Economist. It explains that the underlying economics of the increasing demand of commodities -- due to global population growth and alternative commodity uses (like ethanol from corn) -- and supply that cannot keep up, are driving prices upward (as with wheat, soy and corn). This supply-demand relationship should continue to rise for several years.

However, the demand for gold can be seen as artificial, because it is based on a belief in rising prices due to "other peoples' beliefs in rising prices," or otherwise known as speculation.

There is no real increase in the demand for gold and the supply is not really disappearing. Therefore, while in the short run gold might increase in price, over a longer run, it should go back down, as speculators start to take their profits and confidence in the economy increases.

2. The one who controls the land makes the money, not the one who finds gold. During the gold rush, those who controlled the land on which gold was found made the real money, not the gold diggers. Land owners, who controlled access to the limited resource, extracted significant profits in the form of leasing fees. Think of the average gold digger of the mid-1800s as a precursor to today's typical gambler in Las Vegas. Both mostly lose money by betting on the hope of striking it rich - fast.

So when investing in commodities, you want to examine who controls the access to a specific commodity -- the "land," if you will. Take oil, for example. Companies such as Exxon Mobile (XOM), BP (BP), Chevron (CVX), Royal Dutch Shell (RDS.A), ConocoPhillips (COP) and Total (TOT), practically control most of the world's access to oil. Therefore, these companies will continue to make money.

In the case of corn, seed companies like Monsanto (MON) control access to the commodity. By controlling seeds of popular varieties, these companies can charge growers lucrative "access fees."

3. If you use gold and its cost goes up, you don't make money if you cannot increase your price. When a commodity's price go up, those who use the commodity as a component or ingredient in their product but cannot raise their prices at the same level, end up losing out. This is why gas stations close despite increasing oil prices. They cannot increase their prices as much at the same rate as the big oil companies increase the prices to them. The reasons: competition between gas stations creates price pressure downwards and consumers are somewhat price-sensitive -- even to gas, which doesn't have a mainstream alternative.

This is why Whole Foods (WFMI) is in a tough place right now. Not only is the economy slowing down, but the company is facing more competition in its niche. Again, the costs of a company's "ingredients" are going up and it cannot transfer the full price increase to its customers, (because at some point, even Whole Foods' affluent customers become price-sensitive).