Despite being overlooked by many financial advisors, commodities such as precious metals, oil, and agricultural products can provide a unique avenue for reducing risk and enhancing returns.
Unlike stocks and bonds, which are influenced by broader market trends, commodities move according to industry-specific conditions. This makes them an excellent way to diversify your portfolio and reduce the overall risk. But how exactly do you get started with commodities investing, and what are the different options available to you?
In this article, we’ll take a deep dive into the world of commodities investing, covering everything from the various types of commodity-based investments to the overall outlook for the commodities sector.
Table of Contents
What is Commodity Investing?
Investing in commodities is a thrilling way to diversify your investment portfolio. Commodities are raw materials that have a variety of uses, from being consumed directly like food, to being transformed into other products. Imagine investing in oil, the fuel that powers transportation and industry around the world. The price of oil can have a significant impact on the profitability of many companies, and as an investor, you have the opportunity to profit from that.
You have several options when it comes to investing in commodities. One option is to purchase physical goods like gold, which is often used as a hedge against inflation.
Another option is to invest in Exchange Traded Funds (ETFs) that track specific commodity indexes. This allows you to diversify your investment and reduce risk. You can also buy stocks of commodity-related businesses like oil and gas producers or mining companies, which can provide exposure to the commodity market.
However, keep in mind that commodities can be volatile, so be sure to understand the risks before making any investment decisions.
If you want to take on more risk for the chance of greater returns, you can try using futures contracts. Futures contracts are agreements to buy or sell a commodity at a specific price and date. If you’re right about the price of the underlying commodity, you can make a lot of money, but the opposite is also true.
As exciting as commodity investing can be, it’s important to educate yourself and fully understand the risks involved. That way, you can make informed decisions and avoid potential losses. Keep in mind that events like margin calls can have a significant impact on the success of your trades.
Why Invest in Commodities?
Investing in commodities may seem like a risky move. After all, they don’t produce cash flow and price spikes can be short-lived. But don’t let that discourage you! Here are some compelling reasons why you should consider adding commodities to your investment portfolio:
Inflation Protection
One of the most significant advantages of commodities is their ability to offer inflation protection. As the prices of “hard assets” such as commodities rise over time, they can help protect your portfolio against the erosive effects of inflation. This makes commodities a particularly attractive option for investors who want to maintain their purchasing power over the long term.
Diversification Benefits
Commodities often move in different directions than the broader economy, responding to specific factors unique to each commodity. As a result, they tend to have lower correlation with stocks and bonds. By adding commodities to your portfolio, you can diversify your holdings and reduce risk. This not only helps smooth your returns but also protects your portfolio against sudden shocks in the market.
Hedge Against Risk
Commodities can also be used to hedge against risks in your other investments. For example, if you own shares in an airline that is heavily exposed to the price of oil, you can help offset that risk by owning oil directly. This can help protect your portfolio against losses in case oil prices spike.
5 Ways to Invest in Commodities
If you’re interested in investing in commodities, there are different options available. You can buy the actual products, invest in futures contracts, purchase shares in the companies that produce them, or even invest in ETFs.
1. Futures
Investing in commodities through the futures market is a thrilling way to speculate on the price movements of everything from oil to coffee beans. While it may not be the easiest method, it is certainly one of the most exciting and potentially rewarding.
The futures market allows you to enter a contract by putting up only a fraction of the total value of the commodity. This is called margin trading, and it enables you to use leverage to potentially make huge gains. Of course, as with any high-risk investment, there is the potential for significant losses.
One of the most alluring aspects of trading futures is the low cost of entry. You can start with relatively little capital and still potentially make a fortune. Additionally, you won’t need to put up more money on the contract as long as the trade goes your way, making it a cost-efficient way to invest.
But, as with any investment, there are risks involved. If the trade moves against you and the value of the commodity falls below your maintenance margin, you will have to add more funds to keep the contract open. This means that while futures trading can potentially offer quick profits, it can also lead to substantial losses just as quickly.
2. Physical commodities
For those seeking a tangible investment that can act as a hedge against inflation, owning physical commodities can be an attractive option. While some commodities, such as hogs and cattle, may not be practical for direct ownership, precious metals like gold and silver are popular choices for investors who want to physically own the metals themselves.
There are a variety of ways to purchase bullion, including online dealers and pawn shops, and gold and silver coins can also be bought for their bullion value. However, it’s important to ensure that you’re getting close to the spot price on purchases, and not overpaying for the collector’s value on coins.
Of course, there are risks to owning precious metals directly. The biggest risk is the potential for theft, so it’s crucial to ensure that anything of substantial value is fully protected.
Moreover, if you need to sell your bullion or coins in a hurry, you may not be able to get the full market value for them. This is especially true when selling to a dealer, as they may not be willing to pay the full value of your investment at the time of sale.
3. ETFs of physical commodities
ETFs offer a convenient way to invest in commodities, giving you direct exposure to their market-based pricing without the risks associated with owning physical goods.
With ETFs, you can buy a fund that owns a specific commodity or a combination of them. For instance, you can invest in an ETF that owns gold, oil, or any other commodity you want to get exposure to. This way, you can enjoy the benefits of a “pure play” investment, combined with the simplicity of an ETF.
The best part about investing in commodities through ETFs is that you get direct exposure to the commodity’s price. This means that you can get the best price for your holdings when you decide to sell them. Moreover, you can avoid the biggest risks associated with owning physical commodities, such as the possibility of theft or the cost of storing them.
However, it’s important to note that commodity prices can be very volatile, even more so than stock prices. Therefore, investing in commodity ETFs comes with its own risks. Besides, since commodities don’t generate cash flow, your optimal return will be the return on the commodity minus the price of the ETF.
4. Stock of commodities producers
Are you keen to invest in commodities, but not interested in owning physical commodities that don’t generate cash flow? Don’t worry, you can still benefit from rising commodity prices by investing in producers of those commodities.
When you buy stock in commodity producers, you can enjoy dual benefits. Firstly, if the price of the commodity increases, the company’s profits will typically rise as well. Secondly, the company can gradually increase its production to improve its profits, providing another avenue for your investment to grow.
However, it’s important to be aware of the risks. Investing in commodity producers can be precarious due to the volatile nature of the industry, which experiences cyclical boom and bust periods. Additionally, as these companies require a significant amount of capital, it can be challenging to sustainably grow their businesses.
Furthermore, investing in individual stocks can be a daunting task that requires a lot of research and analysis. Opting for a few stocks instead of a diversified portfolio can increase the risks of your investment.
Therefore, if you’re considering this option, it’s crucial to have a solid understanding of the company and industry before making any decisions.
5. ETFs of commodities producers
ETFs provide an easy and cost-effective way to gain diversified exposure to a range of commodities producers. By buying an ETF that owns a portfolio of producers, you can benefit from the diversification that comes with owning multiple companies, while also gaining exposure to a specific commodity or sector.
For example, if you’re bullish on gold, you can buy a gold miner ETF and enjoy the benefits of cash-flowing producers while betting on the rising price of gold. This can be a great way to gain “pure play” exposure to a specific commodity, without having to pick individual companies.
However, it’s important to remember that investing in ETFs focused on a specific commodity or sector can also come with risks.
While you’re diversified across multiple companies, you’re still narrowly diversified in terms of the types of companies you’re invested in. If the price of that commodity falls, your ETF’s value may also decline, even if the companies within it are performing well.
Learn more: How to Invest in ETFs
Should You Trade Commodities?
Commodity trading is not for the faint of heart. It takes courage, discipline, and a deep understanding of the market to be successful. But if you’re up for the challenge, the potential rewards can be significant.
If you’re considering commodity trading, the first thing to understand is that it’s not the same as investing. Commodity trading involves speculating on the short-term movements of commodity prices, rather than investing for the long-term growth of a company. That means you need to have a solid understanding of the supply-and-demand dynamics of the commodity market, as well as knowledge of historical price trends and current market conditions.
It’s also important to be aware of the high level of risk involved in commodity trading. Unpredictable factors like weather patterns, natural disasters, and disease outbreaks can have a huge impact on commodity prices in the short term, and can cause sudden and significant losses for traders who are not prepared.
That said, commodity trading can be a useful tool for hedging your portfolio against inflation or a bear market. And if you’re willing to take on the risk, there are strategies you can use to reduce your exposure, such as limiting your use of margin.
Ultimately, whether or not commodity trading is right for you depends on your goals and risk tolerance. For long-term growth, most people would find investing in commodity stocks, mutual funds, or ETFs to be a better option.
