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How to Invest in Commodities?
Commodities are basic goods and unprocessed natural resources like precious metals, oil, agricultural products, livestock, and more. They are traded in global commodity markets. Investing in commodities can be an excellent way to diversify an investment portfolio because, historically, their performance has shown little correlation with traditional stock and bond markets.
Furthermore, commodity prices mainly fluctuate based on global supply and demand for each product. For instance, a poor harvest can drive up grain prices, while the discovery of new oil reserves can push down oil prices. This unique dynamic makes investing a small portion of a portfolio in commodities helpful in countering declines in other assets that are more sensitive to economic cycles.
In this guide, we will delve into what commodities are, the reasons to invest in them, their risks and advantages, and the most popular investment methods. This information will help you make a better decision about whether investing in commodities is right for you.
Investing in Commodities
There are several ways to gain exposure to commodities as an asset class:
- Physical ownership. This is the easiest and most direct way to invest in physical goods, such as gold and silver bars. However, it requires finding a reliable distributor, possibly hiring secure storage services, and considering insurance and transportation costs, depending on the desired quantity. Additionally, selling these commodities can be problematic for those in need of quick cash since they generally need to be sold at a discount compared to the spot price. This type of investment is most feasible for precious metals and not for agricultural or livestock products due to obvious reasons related to expiration.
- Futures contracts. These are standardized contracts to buy or sell a specific quantity and quality of a commodity on a predetermined future date at a fixed price. These investments allow for leverage, which means you can potentially achieve substantial gains with relatively small capital but also face significant losses. They also require experience to trade and necessitate having a margin-enabled trading account.
- Exchange-traded funds (ETFs). These funds enable investment in a basket of commodities or track the performance of indices like the S&P GSCI without the need for physical exposure. Like futures contracts, ETFs facilitate diversification with relatively little capital. Their annual fees are typically low, around 0.2%. However, they do not perfectly replicate spot prices and can be quite volatile.
- Mutual funds and investment trusts. These funds invest in companies related to the production, extraction, and processing of commodities. Their fees tend to be higher, ranging from 0.8% to 1% annually. They offer indirect exposure to prices.
- Company stocks. Another way to invest in commodities, widely used by investors, is buying shares of companies focused on sectors like mining, oil, agriculture, or livestock. Although it allows you to benefit from long-term price increases, it also exposes you to specific risks associated with each company. Therefore, a thorough analysis of each company is necessary before investing.
- Alternative investments. Refers to hedge funds or private investments that aggressively invest in commodities with high leverage. These are speculative and high-risk strategies that require professional advice.
Why Invest in Commodities?
There are several reasons why it can be attractive to include a small proportion of commodities in a diversified portfolio.
Historically, commodity prices tend to rise when inflation is high because producers pass on their increased production costs to the final product’s price. For example, if fertilizer and transportation costs rise, prices of agricultural grains and cereals typically increase.
Additionally, during periods of high inflation, the purchasing power of money decreases. However, with rising commodity prices during inflationary times, they maintain or even increase their real value.
Commodities have a relatively low correlation with other financial markets as their behaviour depends mainly on specific supply and demand factors rather than monetary policies or economic data. This contributes to portfolio diversification.
One more reason to consider investing in commodities is that some commodities like oil and precious metals (gold and silver) can experience significant price hikes in short periods due to their natural high volatility resulting from global supply and demand fluctuations. This allows speculative investments to capture extraordinary profits.
For example, since the beginning of 2019, the price of gold has risen by 50.9% from $1,276 to $1,926, due to increasing inflation in the United States.
Finally, in the case of precious metals like gold, they have historically served as a store of value during economic uncertainty and financial crises. Since 1970, gold has been one of the most used commodities to protect against inflation, as its value tends to increase as the purchasing power of fiat currencies decreases.
Risks of Investing in Commodities
Along with providing a number of benefits, investing in commodities carries significant risks and disadvantages, such as:
- High volatility. Commodity prices can fluctuate widely and abruptly due to unpredictable factors like weather, natural disasters, geopolitical conflicts, supply problems, etc. This greatly increases the likelihood of significant losses.
- Speculative nature. Most commodities do not generate cash flows, interest, or dividends. Returns depend entirely on favourable price movements, which are extremely difficult to anticipate.
- External risks. Prices are affected by events beyond the investor’s control, such as sudden regulations, export bans, logistical issues, and more.
- Concentration. Like any investment, focusing on a single commodity implies more risk than having a broadly diversified portfolio, as any event can cause the price to collapse, resulting in partial or total loss of the investment.
- Leverage. Using derivatives and futures contracts to invest in commodities increases the potential risk of losses exceeding the invested capital. Additionally, it requires constant monitoring to avoid losses.
Bottom Line
Investing a small portion of the portfolio in a diversified basket of commodities can provide diversification benefits, inflation protection, and the potential for significant speculative gains in the short term with correct timing.
However, most are inherently volatile and risky investments where luck and external factors play a predominant role. Therefore, as with any high-risk investment, it is advisable to invest only what the investor is willing to lose or seek professional advice to mitigate risks.