What Type of Investor Are You?

While the futures and forex markets are considered “alternative investments,” much of the activity that you will be doing with them is “trading.” Let’s define the differences between investing and trading.

Investing is defined as “the act of committing money or capital to an endeavor (a business, project, real estate, etc.) with the expectation of obtaining an additional income or profit.”

Trading is defined as “to engage in buying and selling for profit.”

These two activities, investing and trading, have the same end goal of profits, but they approach it from two different directions. When you invest, you are committing to the stock or bond that you are purchasing. This is important to be clear on. The buy-and-hold philosophy of stocks and bonds reconfirms that commitment.

When you are “investing” in futures and forex, you are actually “trading.” You are not taking delivery on the tangible goods; 99% of the time, you are simply buying and selling the futures and forex contracts at the first sign of profit or based on your predetermined profit goals.

This fluidity in not becoming committed to an investment but being willing to buy and sell to either make a profit or diminish loss is imperative for your success. The commitment is to profitability, not being right about which direction the market is going.

This is the underlying strength that it will take for you to transition from being a Type A investor, who is looking to get quick rich without understanding the underlying building blocks of futures and forex trading, and a Type B investor, who embraces the building blocks and adapts them to his own risk/reward profile and ultimate profit goals.

Yale Study

Now that we have separated investing and trading, let’s look at what some of the great minds of our times think about futures investing. On June 14, 2004, the Yale International Center for Finance put out a white paper entitled “The Facts and Fantasies about Commodity Futures.” Gary Gorton of the University of Pennsylvania and K. Geert Rowenhorst of the Yale School of Management came to several insightful conclusions. Of the various questions they attempted to answer, these three questions give us the most insight into the appropriateness of this investment class:

1. What are the returns to investing in commodity futures, and how do these returns compare to investing in stocks and bonds?

2. Are commodity futures riskier than stocks?

3. Can commodity futures provide diversification to other asset classes?

In determining their answers to these questions, they took data from the Commodity Research Bureau (CRB) and created an equally weighted index that extended from 1959 to 2004. They removed various commodity contracts that had come and gone over the years.

Second, they concentrated on only one commodity from one exchange, even if that market was traded in multiple exchanges. Volume and liquidity became their determining factor.

Finally, they focused all of their efforts on the front month or contract with the nearest expiration, disregarding other months that the various commodities were traded on.

What Are the Returns to Investing in Commodity Futures, and How Do These Returns Compare to Investing in Stocks and Bonds?

In their research, Gorton and Rowenhorst discovered that over the past 43 years, commodity futures were comparable to the S&P 500, while at the same time they outperformed corporate bonds. There was an average return of 11.02% for both the S&P 500 and the commodity futures. When calculated based on standard deviation, the S&P 500 returns are slightly higher at 14.9% than commodity futures that returned 12.12%.

Are Commodity Futures Riskier than Stocks?

During two different time periods, the 1970s and the 1990s, commodity futures outperformed the S&P 500. This is significant because the volatility of the equally weighted commodity futures return is slightly below the volatility of the S&P 500.

So while the average returns of the S&P 500 and the commodity futures index may be on par, the underlying difference in volatility makes stocks slightly more risky.

Can Commodity Futures Provide Diversification to Other Asset Classes?

In determining the correlation of commodity futures returns with stocks and bonds, the authors chose to look at three different time intervals. They evaluated the returns quarterly, annually, and over the course of a five-year interval. They discovered that commodity futures are negatively correlated to the S&P 500 and long-term bonds. As time goes on, the negative correlation increases. Inversely, commodity futures returns are positively correlated with inflation.

They coupled this data with the months that the equity markets had their worst performance and then calculated the relationship between commodity futures and equities for two time frames: 1% and 5%. During 5% of the worst-performance months, stocks fell an average of 9.18%, while commodities returned 1.43%. During 1% of the worst-performance months, stocks fell an average of 13.87%, while commodities returned an average of 2.32%.

Pros and Cons

The information Gorton and Rowenhorst accumulated doesn’t stop there. The authors then looked at commodity futures in relation to companies that trade in commodities and attempted to determine which market is the better performer.

By publishing this study, Gorton and Rowenhorst made commodities an accessible asset class based on the numbers. They have dispelled many assumptions and myths and, at the same time, have raised the esteem of the commodity futures market to a level of prominence that goes beyond anecdotal and subjective experiences.

By dissecting commodity futures in this way, we can look to the numbers and develop concrete strategies that can properly incorporate commodity futures into a bond and stock portfolio while managing inflationary pressures with an eye toward optimizing returns and minimizing risk.

The key problem with their report is that they take a fictionalized commodity index. They equally weigh each commodity, and then they ignore the various commodity back months to concentrate on the front months only. While this may work for a white paper, what is available to the average investor is completely different.

The data that they use comes from the CRB, which has two of its own indices. The second index that they developed was created solely to take into account the increased volatility of the energy sector of the past several years.

Other commodity indices such as the Goldman Sachs Commodity Index and the Dow Jones Commodity Index are even more heavily weighted in oil, often having a one for one correlation in its movement. It is also important to keep in mind that the private sector will constantly move and shift the weight of its index to match the investment environment at the time. So an index’s remaining static over the course of 50 years is unlikely and will include commodity markets that may be eliminated over time.

Even with these flaws, the authors of this white paper have given a kinder face to commodity futures that can allow for a pure stock and bond investor to find a sense of comfort that he may not be able to get anywhere else.

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