With commodity price increases on the rise, investors are wondering if commodities belong in their portfolios. In the following article, Don McDonald lays it on the line and tells you what he thinks a good investment is, and isn’t.

Any time there is a sharp, protracted increase in the price of anything, the news spreads quickly and investors want a “piece of the action.” This happened in the 1990s with Internet stocks and more recently with real estate. Now, the commodities markets have caught investors’ attention as oil, metals and even orange juice have all jumped in price.

As profits make news, investors look for ways to quickly get involved. While momentum investing is dangerous in any investment vehicle, commodities carry especially high levels of risk. In fact, buying individual commodities futures contracts (which obligate you to a future purchase at prices set today) is so risky that investors must prove in advance that they have the substantial resources available to absorb the massive possible losses.

Investors can also buy commodity futures options. Here, losses in most cases are limited to the amount invested. However, buying an option is not all that different from playing the tables at a casino. Instead of betting on a number, a color, or a score, you bet on the direction of a commodity. If you bet wrong, you lose everything that you bet.

The huge risks associated with individual commodities transactions led to the creation of commodities funds. Because they let people invest in a basket of commodities, these funds are far less risky than individual contracts or options (or even buying little lumps of gold or silver). But they are still risky, and I think they make pretty lousy long-term investments.

My definition of a good investment is something that has the potential to grow more valuable over time. Commodities can become more valuable, but as they do their value is quickly reflected in the value of the goods and services produced with them. That means that, in terms of creating real wealth, over and above the rate of inflation, commodities fail miserably (unless you are in the business of actually creating the commodity).

Think of it this way: If you put $100,000 into gold bullion and locked it up for 20 years you would still have the same pile of gold bullion. Assuming it tracked inflation at 3.5 percent, it would be worth about $200,000. That pile of gold got no bigger, and it provided you with no real increase in wealth. Although gold’s purchasing power has varied tremendously over short periods of time, the same is not true over long periods of time. An ounce of gold in 1906 would buy you about the same number of potatoes then as you can get for an ounce of gold today.

But, if you had invested that money in a well-run business (or a fund of businesses) that grew at a 6 percent annual rate (which is a conservative rate of growth by historical standards) you would have over $400,000. That’s a real increase in your wealth (and the number of potatoes you can buy)!

As a business grows, the value of what it creates has a multiplier effect on the economy; just think computer chip. Of course, not all businesses grow, but enough do that the value of the world’s economy has steadily increased over centuries. That is why I am in favor of a diversified portfolio of businesses (stocks) when it comes to long-term investments.