Interested in investing outside the stock market? Then it’s worth considering investing in commodities.
Commodities are physical materials typically bought and sold in bulk, such as oil, gold, copper, and wheat. Commodities collectively make up a massive global market since they’re used for building, energy, food, and more.
In this guide, we’ll explain why commodities could be a good addition to your portfolio and cover everything you need to know about how to invest in commodities.
Let’s get started!
What Is A Commodity?
A commodity is a raw material that is typically bought and sold in large quantities. Common examples of commodities include energy sources like crude oil and natural gas, metals like gold, silver, and copper, and foodstuffs like wheat, soybeans, and coffee beans. There are hundreds of different types of commodities available for trading, ranging from zinc to orange juice to timber.
Why Invest In Commodities?
The main reason that many long-term investors look to commodities is portfolio diversification. Changes in the price of commodities are often very decoupled from changes in the US stock market. So, during a downturn in the stock market, commodities could represent a portion of your portfolio that holds up relatively well or even increases in value.
The reason for this decoupling is that commodities represent a different part of the global economy than stocks. The price of many metals, for example, is more dependent on the construction industry in developing regions like African and Southeast Asia than on the latest US stock news. Agricultural products tend to move in price based on changes in supply, which often fluctuates because of environmental conditions like drought or an unusually good growing season.
Another important benefit to commodities is that they’re relatively insulated from inflation. While rising inflation typically diminishes the value of stocks, bonds, and CDs, the price of many commodities rises along with inflation.
Commodities Vs. Other Investments
Commodities are often considered riskier investments than stocks and bonds. That’s in part because the prices of commodities tend to be more volatile.
In addition, the risk inherent in specific commodities can be hard to understand or to see in full. The price of wheat, for example, is subject not just to environmental conditions in major wheat-growing regions around the world. It can also change as a result of trade agreements, changing consumer preferences, and changes in currency values. Accurately predicting whether a specific commodity’s value will rise or fall – both in the short term and over the long term – is extremely difficult. The stock market, on the other hand, has historically risen in value over time and investments like bonds offer defined returns.
Another thing to keep in mind is that while the stock market often rises or falls in aggregate (although there may be divergences between specific sectors), individual commodities can react to market news and events very differently from one another. The price of copper, for example, is most sensitive to global construction, while the price of coffee beans largely depends on agricultural production. As a result, investing in a single commodity can be very risky.
How To Invest In Commodities
There are several ways to invest in commodities. If you want to invest in an individual commodity, like crude oil, the best way to do it is with futures contracts.
Futures are an agreement to buy or sell a specific commodity at an agreed-upon price at an agreed-upon date in the future. Unlike options contracts, futures are binding agreements that must be exercised. That means that if you want to invest in, say, crude oil, you must sell your futures contract or roll it over into a new contract before it expires. Otherwise, you could be on the hook for accepting delivery of physical barrels of crude oil.
Futures contracts can be complex and aren’t offered by many stock brokers. However, they’re not you’re only option for investing in commodities.
ETFs and mutual funds also offer exposure to commodities and are much more accessible than futures contracts. There are many ETF that buy futures contracts for a wide range of commodities, giving you exposure to this market without requiring you to manage contracts and expiration dates. You can also find funds that offer exposure to specific subsets of commodities, such as metals, energy products, or agricultural products.
It’s also possible to invest in stocks to get exposure to some types of commodities. For example, you can invest in oil companies like Exxon, Shell, and BP to get exposure to the price of crude oil. Keep in mind, however, that companies aren’t perfect proxies for the commodities you may want to invest in. In addition, investing in stocks rather than commodities diminishes the diversification that you get from investing in commodities in the first place.
Tips For Investing In Commodities
If you’re considering investing in commodities, we have a few tips to help you succeed:
Commodities Are Risky
Commodities are more volatile and generally riskier than investments like stocks and bonds. Most investors should allocate 20% of their portfolio or less to commodity investing.
Stick To Funds
New commodity investors are generally best served by sticking to commodity ETFs and mutual funds instead of buying futures contracts. That’s because funds offer built-in diversification. A single fund may invest in multiple unrelated commodities, for example, or it may invest in a mix of futures contracts and stocks for a single commodity.
Futures Involve Margin
If you do decide to buy futures contracts, it’s important to keep in mind that futures typically involve margin. The price of the contract might be small, but the total cost of the commodity being traded through the contract is large. Small losses can multiply quickly when investing in futures contracts, so tread carefully.
Commodity Prices Are Often Cyclical
The prices of many commodities rise and fall in cycles. Crude oil is characterized by boom-and-bust cycles that typically happen every decade or so. Copper and zinc prices rise and fall with economic cycles. Demand for some commodities, like natural gas, rise in the winter and fall in the summer or vice versa.
Conclusion: How To Invest In Commodities
Investing in commodities can be a good way to diversify your portfolio away from stocks and to hedge against long-term inflation. However, commodity investing is risky, so only commit a small portion of your portfolio to commodities. In addition, it’s a good idea to invest in commodities through diversified ETFs and mutual funds rather than through individual futures contracts.
