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Sunday, February 13, 2011

Commodities: The Other Market

There’s a huge amount of of interest in the fate of the New York Stock Exchange right now. That’s because so many Americans have retirements and savings invested in the stock market. Granted, as my Forbes colleague said yesterday, investors are actually little affected by a potential and (as I said) politically-sensitive merger between NYSE Euronext and Deutsche Börse. But nevertheless, the NYSE is a powerful symbol of investing.

It’s such a powerful symbol, in fact, that many Americans assume that all markets work like the stock market does, that you can buy a piece of anything including commodities, where prices are booming. Just today the WSJ reported that cotton prices flirted with a high. Investors — including doctors, lawyers, and pensioners, all used to investing in stocks — are pouring billions of dollars into commodities markets in an effort to own a piece of this.

But even as they’re dumping money into commodities, they fail to understand the fundamental ways in which these markets are different from the stock market. I tried to explain that in a story in this week’s Forbes.

Many of investors’ dollars meant for commodities end up in futures products traded on exchanges like CME Group and the IntercontinentalExchange. And futures were not built for investors, they were built for hedgers and speculators. Hedgers might be Kraft,which is feeling the pinch of rising prices, or Southwest Airlines or BP. Speculators can be professional traders, or amateurs with a futures broker.
Also, despite the cheeky headline on the commodities story I wrote, you don’t usually buy and own some of a commodity in the way you buy and own part of a company. It’s not easy to buy and sell physical commodities. Futures and other derivatives contracts are proxies, and they are temporary contracts that expire.

Because of all the differences, much of the conventional wisdom from the stock world doesn’t apply. In the stock world, it’s a good idea to buy an index fund because it’s a low-cost way to get a basket of investments. In the derivatives world, it’s often a bad idea to buy a passive index fund. People who do that routinely give away money to other players in the market.

So yes, the NYSE taught us to invest, and we love it for that. But other markets work differently. It pays – literally, pays – to understand that.

Disclosure I am long CFD shares. 

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