When creating an investment portfolio, investing in commodities is frequent; many financial experts only advise investors to allocate assets to stocks and bonds (or funds holding these two asset classes). Yet, other experts contended that in order to assist investors in lowering risk and even out returns, portfolios should be widely diversified.
And that’s where investing in commodities comes in. Commodities, including precious metals, energy, agricultural products, and more, fluctuate in response to factors unique to their respective industries. These may be appealing trades as a result if you want to diversify your portfolio.
Here are a few things to take into account if you’re unsure of how to begin investing in commodities, along with a few strategies to consider and potential pitfalls.
Understanding commodities and investing
Commodities are raw materials, such as food, that are either used directly or indirectly to generate other goods. There are many ways to invest in commodities. Oil is a resource that is employed in the creation of a wide range of products and services. Airlines spend a lot of money on fuel for their aircraft, and the price of oil can significantly affect how profitable an airline is.
Buying physical commodities like gold or investing in exchange-traded funds (ETFs) that follow particular commodity indexes are two ways you can invest in commodities. Also, you can invest in the stocks of companies engaged in the production of commodities like oil and gas or precious metals. Before investing in commodities, make sure you understand the risks you’re facing because they can be highly volatile.
With futures contracts, which are agreements to buy or sell a commodity at a specified price and date, you can also benefit from commodities. If you predict the price of the underlying commodity correctly, futures contracts can make you a lot of money, but they can also cost you a lot of money. Make sure you are aware of the dangers so you can prevent margin calls and other situations that can affect the outcome of your trade, or at the very least, be prepared for them.
Investing in commodities: What to look out for
Investors may refer to commodities as if they were a single entity, but in reality, they are actually dozens of distinct items, each of which is subject to its own unique supply and demand.
Popular commodities
The following are some of the most popular commodities:
- (Gold, silver, platinum, etc.) precious metals
- Oil
- Natural gas
- Corn
- Wheat
- Soybeans
- Cattle
- Hogs
- Lumber
Therefore, it’s crucial to concentrate on the unique factors driving each commodity when you’re looking for investments in them. For instance, if the price of gold is rising in the futures market, it might be because of a variety of distinct supply and demand problems unrelated to, say, natural gas or hogs.
As a result, commodity investing is much more complicated than the general term suggests.
Rule of supply and demand
Supply and demand are the key factors in commodity industries. Every commodity industry has a product that is essentially the same. Cattle are cattle, and wheat is wheat. Because of this, all producers are price-takers and are unable to set prices in normal circumstances. With many consumers demanding an undifferentiated product and suppliers unable to provide differentiated products, many commodity industries are excellent examples of what are known as perfectly competitive industries.
So supply and demand imbalances, which can happen for a variety of reasons, are what drive price changes. If supply becomes limited or demand increases, prices could increase. One of the most notable instances was the rise in lumber prices in 2021 as a result of the supply being partially restored after it had been shut down as part of the larger COVID economic slowdown.
However, if supply increases or demand decreases, prices could return to earlier levels or even decrease. As supply resumes and the situation returns to normal, the lumber price is also declining.
Understanding the supply-demand situation, where it is going, and how quickly it will arrive is necessary for investing in commodities. Prices frequently fluctuate and can rise or fall suddenly. As the old adage goes, “high prices are the cure for high prices.” In other words, if suppliers can profit from high prices by increasing production, they will do so, and prices will eventually fall to normal levels.
Lowest cost wins in commodities
Companies that produce at the lowest cost win in this situation because they are price-takers in commodity industries. They make the highest profit per unit and can continue to operate as long as the market is open, regardless of how much the price of the commodity declines.
The businesses that produce at high costs are typically the most precarious. If prices drop, they won’t be able to produce at a profit and since they are price-takers, they won’t be able to make any more money. Therefore, if the industry doesn’t recover quickly enough, they might eventually go bankrupt.
Obviously, if you’re trading the price of the commodity itself, you might have conflicting opinions about any particular producer, but if supply is hampered, it could contribute to price increases.
Price increases are frequently transient.
Over time prices of commodities will tend to move toward an equilibrium price that matches demand and supply. But in the short term, commodity prices are volatile and they will tend to overshoot this equilibrium price on both the upside and downside. So, markets often overcorrect as producers rush in to correct a lack of supply. But then they might stick around to recoup their investment and end up staying too long — pushing the commodity price below a sustainable level.
So price spikes and even massive declines are often short-lived. The spikes bring marginal suppliers online, while later declines shake out the marginal suppliers.
Risks of commodity investing
Volatility – Because of how volatile commodity prices may be, your portfolio is susceptible to significant price movements. The volatility is a significant risk as well as a potential opportunity.
Speculative – If your goal is to make money simply from changes in commodity prices, you are engaging in speculative activity rather than investing. Your asset won’t generate any underlying cash flows, thus the price of the commodity will be your only source of income.
Geopolitical events: Commodities are particularly vulnerable to global geopolitical events. For instance, prices for petrol and gasoline rose sharply in the wake of Russia’s invasion of Ukraine in 2022.
Weather – Weather patterns all across the world have an impact on commodity prices. The supply may suffer if adverse weather affects a commodity’s growth circumstances, driving up costs.
Concentration – Investing in commodities frequently entails having a significant exposure to the price of a particular asset, such as gold or oil. There are ways to partly diversify your risk, but you won’t be completely shielded if the commodity price declines.
Why investing in commodities is popular?
What exactly interests investors and traders in commodities if they don’t generate cash flow and price spikes are frequently transient? Some of the main explanations for their widespread appeal are as follows:
Protection from inflation
Commodities can safeguard your portfolio from inflation because the cost of these “hard assets” may increase over time in line with inflation.
Low correlation to other assets
Commodity-specific characteristics play a large role in how prices fluctuate, frequently for reasons that are very distinct from those affecting the overall economy. Their performance has a lower correlation with equities and bonds as a result. Commodities can be used to diversify a portfolio, lowering risk and smoothing returns because they have lower correlations with other asset types.
Defend other investments using a hedge: Your other investments may be less risky if you own a commodity. You can directly own oil and help reduce portfolio risk if, for instance, you own a business like an airline that may be highly vulnerable to the price of oil and would suffer if it soared.
Final Thoughts
Commodity investing helps diversify your portfolio, but many – perhaps most – portfolios can do so without the additional exposure if they are already well-diversified. You can still enter the commodity trading market in a variety of methods, but you should be aware of the advantages and disadvantages of each strategy. But keep in mind that price increases are frequently transient, thus commodities might not be the best long-term investments.
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