Commodities are goods used in commerce. Traditionally, commodities have included goods such as crude oil, gas, grains, metals, or coffee. However, goods such as foreign currencies, internet bandwidth, or even cell phone minutes are now considered commodities as well.
Commodities are popular investments due to the high demand for these goods. However, there are several risks associated with investing in commodities. There are also a few downsides that might not make this type of investment a good addition to your portfolio.
Commodities are not for every investor, but they can yield high returns if you pick lucrative commodities, invest at an opportune time, and follow a strategy that is adapted to this market. It is crucial to educate yourself about commodities if youâre thinking about investing in them.
âWhen you look at a commodities market you need hedgers and speculators. If you donât have one, you donât have a market. Thatâs how it works.â
â T. Boone Pickens
From a historical point of view, commodities usually perform very well compared to other investment products. The average return is higher than most investment products and risks are fairly low compared to some markets. However, adopting the wrong approach to commodity investing could have disastrous results for your portfolio.
Most investors choose not to allocate more than 10% of their assets to the commodity market due to high price fluctuations. If youâre a more conservative investor, allocating between 4% and 6% of your assets to this market would most likely be a better option for you.
Investing in commodities for the wrong reasons or at the wrong moment will lead to a loss.
Consider these reasons for including commodities in your investment portfolio:
- Commodities give you an opportunity to diversify your investments. If youâre only investing in stocks, you can gain exposure to a different market with commodities.
- The reasoning behind diversification is that your portfolio will not lose all its value if one market doesnât perform well.
- Diversification doesnât completely eliminate the risks of investing, but it lowers your chances of losing money.
- Commodities provide you with a hedge against poor stock market or bond performance. Historically, commodities tend to be independent from the stock market and negatively correlated to bonds. This means the price of commodities, especially futures contracts, tend to go up whenever bonds lose their value.
- Commodities are the only investment vehicle that has this negative correlation to bonds.
- Commodities make great long-term investments due to the increasing demand. These are the main factors causing demand to go up in most sectors:
- Countries like India and China are developing their infrastructure as well as their manufacturing sector. China is currently the largest consumer of coal, iron, steel, and aluminum. Other developing countries will enter an intense industrial phase once China and India progress towards a third sector economy.
- Some sectors of the commodity market suffer from a lack of investment. This means no new discoveries of resources have been made in years, which leads to higher prices.
- Discovering new resources is not as easy as it used to be. Some deposits of valuable commodities are difficult to access because they are located in unstable countries. This instability leads to higher prices and smaller quantities of commodities being available.
- Extracting and distributing commodities in a manner that is respectful of the environment leads to higher prices and creates a lengthier process.
- Having access to qualified workers and equipment to extract and distribute commodities is not easy. This contributes to reducing the quantity of commodities available on the market.
- Commodities keep you safe from inflation. If the inflation rate goes up, demand on the commodity market usually goes up, which leads to higher prices. If some of your investments are likely to suffer if inflation goes up, adding commodities to your portfolio is a good way to prevent inflation from negatively affecting your portfolio.
- Commodities are a safety net. In case of a natural disaster, financial crisis, or a war, stocks and bonds can quickly lose their value. On the other hand, commodities will retain their value and many even go up.
These are excellent reasons to include commodities as one part of your portfolio. Approaching the commodity market for any other reason could be very risky.
âCommodities tend to zig when the equity markets zag.â
â Jim Rogers
Even though the commodity market carries some risks, commodities are a very popular investment vehicle.
Consider these advantages of allocating a reasonable percentage of your assets to the commodity market:
- Returns are potentially high. As supplies of natural resources diminish, the demand for many commodities increases and prices steadily go up.
- Commodities could help your portfolio receive steady returns. If you already have stocks and bonds, you can create a portfolio that yields steady returns by investing in commodities. Whenever your stocks and bonds do not perform well, the commodities you invested in should provide you with the opportunity to yield interesting returns.
- High inflation means the US dollar loses some of its value. Your stocks and bonds will not be as valuable as before, but more dollars will be needed to import goods from other countries, which will cause your investments in commodities to gain value.
- Some commodities can bring good returns in a bear market. If stocks and bonds do not perform well, many individual investors will get rid of them to invest in commodities instead, raising the demand and the price for commodities.
- Most commodities are not influenced by market movements. Demand and prices actually go up for commodities such as precious metals in periods of economic uncertainty.
- Commodities have low risks and low volatility compared to other investment products. They make a good addition to your portfolio if you need to compensate for other investments that carry high risks.
- Commodities are very liquid. You can sell whenever you want to.
- Lower fees. Compared to other investments, many commodities transactions carry lower fees and margins.
- Commodity futures are more transparent than other investment vehicles. The commodity market is regulated, and the cost of a commodity is the same from one financial institution to another.
- Less expensive than many investments. Thanks to online trading platforms, itâs possible to get started with a small initial investment.
âThe price of a commodity will never go to zero. When you invest in commodities futures, youâre not buying a piece of paper that says you own an intangible piece of company that can go bankrupt.â
â Jim Rogers
Take the time to weigh the pros and cons of investing in commodities before deciding if this market is right for you.
These are the downsides of investing in commodities:
- Returns can be very volatile. Historically, commodity index funds have actually produced negative returns.
- Investing in commodities can give you a false sense of security. Commodities are more tangible than other assets but this does not mean their value cannot drop.
- Even though commodities carry high potential returns, supply and demand is difficult to foresee. A natural disaster or unstable political situation in another country could drastically change the market.
- Speculation is another thing to watch out for. Some news can cause investors to overreact and lead to high prices that cannot be sustained. For instance, weather predictions can have a high impact on the price of orange juice as a commodity while a low overall confidence level always leads to higher prices for precious metals.
- The commodity market can change very quickly, which means you could lose a lot before you have time to react. Investing in commodity futures means you agree to buying or selling a commodity at a fixed price in the near future. You might end up having to spend more capital than you initially planned if the market changes.
- Some commodity mutual funds carry high risks because they give you exposure to only one sector. Avoid assuming that a mutual fund covers enough sectors to provide you with a good diversification strategy.
- The commodity market can be complex. Itâs important to stay informed and adjust your investment strategy as needed.
- Irregular income. Commodities do not provide you with a regular income like financial products with dividends.
These are the main downsides you need to be aware of before you invest in the commodity market. Investing in commodities also carries some risks that need to be properly assessed.
âThe problem with commodities is that you are betting on what someone else would pay for them in six months. The commodity itself isnât going to do anything for youâ¦.it is an entirely different game to buy a lump of something and hope that somebody else pays you more for that lump two years from now than it is to buy something that you expect to produce income for you over time.â
â Warren Buffett
There are three main risks of investing in commodities:
- Geopolitical risks. For instance, companies that extract oil in the Middle East have to stay on good terms with foreign governments. International issues regarding access to natural resources are common and foreign governments have kicked companies out before.
- You can lower risks by investing in large companies that have an excellent track record, but geopolitical risks cannot be avoided altogether.
- Speculation. Overpaying for a commodity because its perceived value is higher than its actual value is not a sound way to invest your money.
- You can avoid making mistakes due to speculation by using trustworthy reports from the Commodity Futures Trading Commission to stay up to date with what is happening on the commodity market.
- Inexperience. There is a lot of hype on some sectors but very little tangible information.
- If you lack experience, focus on popular commodities such as metals, oil, and grains, since trustworthy information is fairly easy to find for these sectors.
âGold and silver, like other commodities, have an intrinsic value, which is not arbitrary, but is dependent on their scarcity, the quantity of labour bestowed in procuring them, and the value of the capital employed in the mines which produce them.â
â David Ricardo
There are several ways of investing in commodities. If you want to invest in commodities for diversification purposes, it is best to gain exposure to commodities through several investment vehicles.
Purchasing a physical commodity and reselling it later is the simplest way to invest on this market.
These are the advantages of purchasing physical commodities:
- Your investment is entirely independent of financial institutions, which is an advantage in case of a financial crisis. This is a good option if you do not feel comfortable with trusting one financial institution with all your assets.
- Physical commodities are liquid, since you have direct access to them and can sell whenever you decide to. Some commodities such as grains or construction materials have other uses than resale and commodities such as gold bullions can be deposited in your IRA.
There are also some downsides to purchasing physical commodities:
- Transportation and storage is not convenient for every type of commodity. Buying physical commodities is ideal if you are investing in precious metals and have a safe where you can keep them, but purchasing and storing barrels of crude oil or grains is not practical.
- Storing the commodities you invested in adds some risks. Some commodities can spoil if they arenât stored properly. Your investment could also be stolen.
Futures contracts are the most popular way of gaining exposure to the commodity market. Futures are especially popular among investors who want exposure to crude oil, natural oil, grains, cattle, and other similar commodities.
A futures contract is an agreement to purchase or sell a commodity at a specific date at a set price. Most investors who are interested in futures contracts have a commercial use for these commodities and use these contracts to create a hedge in case prices change.
However, individual investors can benefit from futures contracts since prices can change in their favor. Individual investors get out of the contract before the purchase or delivery of the goods is required. Options are often associated with futures contracts to balance fluctuations in prices.
These are the main advantages of adding futures contracts to your portfolio:
- Futures contracts can be added to your portfolio as long or short positions.
- There is a large potential for profit due to leverage being available on these contracts. Leverage also makes it possible to get started with a small initial sum.
These are the downsides:
- Futures contracts can be purchased through brokers who require you to deposit a percentage of the price of the contract you want to invest in. If the futures contract you invested in starts losing value, your broker will place a margin call and require you to deposit more money in your account.
- Using leverage means you can lose a lot if prices do not shift as expected. It is best not to use leverage if you lack experience.
- The futures market can be very volatile. It is crucial to do some research first and to invest in commodities you are familiar with.
Stocks do not allow you to directly invest in a commodity, but rather in a company with a value closely connected to the price of a commodity. This approach allows you to gain exposure to a sector on several levels. For example, you can gain exposure to crude oil on different levels by purchasing stocks of a driller, refiner, and tanker company.
Using stocks to gain exposure to commodities is an approach that provides you with a number of advantages:
- Stocks are liquid. You can purchase stocks and decide to sell them or to consolidate an existing position at any time.
- Stock options are a good way to get started on the commodity market if you only have a small sum to invest.
- Stock investments can be managed through your brokerage account. Information is easy to find since companies have to release financial reports on a regular basis.
- Stocks are less volatile than futures contracts.
Investing in stocks gives you exposure to the commodity market, but does not allow you to use commodities as a way of diversifying a portfolio that already includes some stocks.
Besides, there are some downsides to investing in stocks connected to commodities:
- Buying shares of a company that extracts or distributes a commodity gives you exposure to this commodity, but the price of the stock is not aligned on the price of the commodity. Other factors will influence the price of the stock, such as the way the company is managed or how it handles competition.
- Stock prices can change very quickly. The company you invested in can go under regardless of how the commodity is performing on the market.
Exchange Traded Funds, or ETFs, can track the price of a commodity by investing in futures contracts or by actually storing a commodity.
Exchange Traded Notes, or ETNs, refer to the debt of a company. ETNs can give you exposure to the commodity market if you use this investment vehicle to purchase shares of the debt of a company that extracts or distributes a commodity.
ETFs and ETNs are good investment vehicles for beginners and are traded like stocks, but without the high volatility.
These are the main advantages of investing in ETFs and ETNs:
- ETFs and ETNs are traded like stocks, are easy to manage and do not carry any management fees.
- ETFs and ETNs provide you with an opportunity to take advantage of price fluctuations on the commodity market without the high volatility and risks of other investment vehicles.
Itâs also important to consider these risks:
- ETFs and ETNs can lose value very quickly if the price of a commodity drops.
- These investment vehicles do not cover every commodity. You can use them to gain exposure to the most popular commodities, but you will not find ETFs or ETNs that give you exposure to emerging markets.
- There are credit risks associated with ETNs. Since you are purchasing shares of a companyâs debt, your investment is subject to the risk of the company going bankrupt and never re-paying the debt.
Mutual funds give you exposure to the commodity market by investing in stocks of companies directly involved in this market. On the other hand, index funds invest in futures contracts and give you exposure to commodities in a more direct manner.
There are some advantages to using mutual funds or index funds to gain exposure to commodities:
- These funds are managed by professionals. Mutual funds and index funds are ideal investment vehicles if you lack experience or do not have time to manage your portfolio.
- Shares of funds are liquid assets. You can buy shares of a mutual or index fund at any time and decide to sell whenever you want to.
- Finding funds that cover a wide range of commodities is fairly easy. Mutual and index funds are a good option if you are looking for a way to gain exposure to different markets without having a lot to invest.
Consider, also, these disadvantages:
- Investing in funds can be costly. You might have to pay management fees as well as a sale charge when you decide to sell your shares.
- Mutual funds do not perfectly reflect commodity prices, since these funds invest in shares of different companies and not in the commodity itself.
âPrudence is what makes someone a great commodities trader – the capacity to face reality squarely in the eye without allowing emotion or ego to get in the way. It’s what is needed by every quarterback or battlefield general.â
Commodities are a great way to balance and diversify your portfolio. Ask yourself what asset allocation strategy works best for you. Most investors do not allocate more than 10% of their portfolio to this market.
The main disadvantages of commodities are that prices can fluctuate a lot, sometimes on a very short time-frame, and that the factors influencing prices are very difficult to predict. On the plus side, commodities are always in demand and there are several ways to gain exposure to this market.
Investing in commodities requires you to educate yourself about the market and to select the best investment vehicles in view of your goals and willingness to take risks.
A wise strategy when investing in commodities is to use them to diversify your portfolio by investing in different sectors and using different investment products.