Advantages and risks within commoditiy investments
You can invest in hundreds of types of investments, but how do you know whether commodities deserve a place in your portfolio? Is it good to invest in commodities?
Let's start by walking through the definition of commodity investing, the different types of commodities and how to buy them through various vehicles (stocks, ETFs, futures). We'll also shine a light on the pros and cons of investing in commodities and the recent trends in commodity trading.
Once you’ve learned the basics of commodities, you can start to determine whether you want to find them a place in your portfolio.
What is commodity investing?
When you invest in commodities, you can invest in raw materials — from industrial metals, such as copper and steel, to livestock — on an exchange. Commodity investing thrives or falls based on supply and demand, kind of like a domino effect.
For example, bad weather in the Midwest can affect corn crops and push up the cost of food that contains corn in South America. In addition, a war in eastern Europe might affect oil and gas prices worldwide. It's a good idea to keep an eye on what's going on throughout the world and how it affects the stock market.
Generally, commodities are split into four main categories: energy, metals, agriculture and livestock. For any investor, the commodities to invest in depend on your goals and interests. For example, if you're an orange grower, you may already have an idea of how to invest in oranges or maybe even lemons.
You buy and sell commodities on a commodity exchange. You can keep track of commodities on the Bloomberg Commodity Index (BCOM), which tracks prices of futures contracts on physical commodities on the commodity markets, similar to how the S&P 500 is instrumental for the stock market.
Types of commodities
Let's go over some details about the four types of commodities we listed above: metals, energy, agriculture and livestock.
Metals such as silver, gold, platinum and copper drive industrial production and construction. Precious metals can diversify your portfolio and may act as an inflation hedge. Gold might come to the forefront first, but it's not the only type of metal available to investors.
Energy commodities and trading include crude oil, natural gas, gasoline or heating oil that you can trade or invest in. Fluctuating energy prices might actually make them attractive to traders.
Agricultural crops like corn, beans, rice and wheat provide a source of food for people and animals across the globe.
Eggs, pork and cattle are examples of livestock commodities. Animals and animal products are considered soft commodities and differ from hard commodities (such as copper or iron), which are taken from the earth instead of grown.
How to buy commodities
How do you buy commodities? Let's look at the different processes, whether you buy stocks, ETFs, futures, CPOs or even physical commodities.
Once you're clear on the basics of commodities, you can dive into commodity derivatives, which are tools that allow you to profit from certain commodities without actually holding onto them physically (although it's certainly possible to hold them physically).
Investing in commodities through stocks
You can invest in commodities by buying stocks online, but what are commodity stocks? A stock represents one small sliver of ownership in a company by investing through the stock market. When you invest in commodities through stocks, you invest in a company that manufactures, processes or grows the type of commodity you prefer to invest in. You can buy any number of commodity stocks you want, though it's a good idea to invest in companies in which you've done a lot of research.
Investing in commodities through ETFs
What is an ETF? It's a bundle of securities that track an underlying index. A commodity index is an investment vehicle that tracks a basket of commodities and which measures price and performance.
Similar to stocks, you can buy and sell ETFs, but you can buy and sell them throughout the trading day instead of just once a day. You can buy commodity ETFs with an online or traditional broker.
Investing in commodities through futures
Futures contracts are agreements in which you agree to buy or sell shares at a certain time in the future for a predetermined price. You can profit from futures contracts when the value of the commodity changes. You may not want to start out with futures if you're a new investor, however, because they tend to be speculative.
Investing in commodities through a CPO
A commodity pool operator (CPO) registered with the Commodities Futures Trading Commission (CFTC), which may work for a hedge fund or investment fund that takes positions in commodities, manages pooled funds that invest in commodities futures and related securities.
Investing in physical commodities
You can buy a physical commodity, for instance, in the form of gold bullion or gold bars. However, the size of some of these commodities and/or the logistics of keeping them can make it hard to hold onto them as an actual, physical investment. This is generally why people look for alternatives for investing in commodities (instead of storing dozens of heavy gold bars or raising a herd of pigs).
No matter your approach, check into the commodity futures trading commission that you might have to pay for commodities.
Advantages of investing in commodities
Why invest in commodities? In short, they can offer diversification and have the potential to yield returns and hedge against inflation. Let's go over these advantages:
Diversification: Commodities can add exposure to a different sector and diversify your stock and bond portfolio. However, it's important to remember that just investing in wheat futures, for example, isn't diversification, because you're investing in just one type of commodity.
Boost in returns: There’s the potential of boosting your portfolio when you invest in commodities, though your returns depend on external factors, such as economic conditions, inflation and worldwide commodity prices.
Hedge against inflation: When inflation rears its ugly head, commodities can provide a hedge, though it's important to understand that commodities can be much more volatile than other types of investments.
Risks of investing in commodities
Commodities can be risky and speculative. More specifically, the first risk is volatility. As mentioned before, commodities are affected by what happens worldwide. For example, in 2020, the pandemic caused a shift in the world’s supply and demand of oil and majorly affected the price of oil. Other things such as import controls, worldwide competition and government regulations all affect commodities.
Commodities are at risk of faltering due to political and currency instability. You can change your exposure to risk by investing in a fund instead of putting all your eggs into one basket with one type of commodity investment.
You might also wonder: Is commodity trading good for beginners? It's a good idea to start slow with trading or investing, particularly if you're new at it — especially when it comes to trading. Typically, trading involves buying and selling securities over a short period of time (sometimes even within a matter of hours), and investing means that you buy and hold investments over a longer period. Short-term investing can be riskier than buy-and-hold investing because the price of a security might go down instead of up or vice versa. If you use margin when trading, it can be even riskier because you're borrowing money to trade.
What are the most traded commodities in 2022?
The COVID-19 pandemic has put several wrenches in the practice of investing in commodities. In addition, inflation has affected the commodities market in 2022. Here are a few commodities that have increased in value:
Gold: Gold has rallied, though prices could drift lower in 2022 and 2023 as central banks raise interest rates and lift bond yields.
Oil: Crude oil is one of the most-benefited commodities in the world over the past year because the price of oil has risen. The price of both Brent and West Texas Intermediate (WTI) crude oil have increased to more than $100 per barrel.
Natural gas: Natural gas prices have zipped higher over the beginning of 2022, which has caused financial strain for homeowners and businesses. However, this has resulted in high points for natural gas stocks.
How should commodities be used in an investment portfolio?
You can invest in commodities directly, through mutual funds and ETFs, or with futures for many different reasons: through a buy-and-hold strategy, as a way to diversify your portfolio and to hedge against inflation.
However, it's very important to be mindful of the risks and consider your goals, including identifying how you'll invest them as part of a well-diversified portfolio. Opting for mutual funds through institutional investors (companies or organizations that invest money on behalf of other people) might be a more beneficial way to invest in commodities for your needs. On the other hand, commodity futures might make more sense for you — it simply depends on your short- and long-term goals.