Over the years, the number of investors has increased considerably. Due to the easier access to investments and multiple selections, investors can choose the right choice for themselves. Commodities are one of the most popular investments. This was driven by rising inflation reaching a 40-year high. Moreover, bond yields have remained historically low, and cryptocurrencies have been extremely sluggish. Many investors turn to real assets like commodities to support their portfolios.
This article will get you to know more about investing in commodities. Investors can invest in many forms such as investing in the futures market, exchange-traded funds, or by purchasing individual commodity-related stocks.
List of contents
What are Commodities?
Commodities are assets that are commonly traded. They are products that can be used as the underlying asset of other products whether it is a raw material used in the manufacturing of goods or services. Products used as raw materials in the manufacture of finished products, consumer-sold finished products, on the other hand, are also commodities as well.
Commodities include everything from raw materials to finished goods. The quality of a given commodity may vary slightly, but it is largely consistent across producers. Commodities that are traded on an exchange must also meet certain minimum standards, also known as a basis grade.
Types of Commodities
Commodities are divided into 2 categories: hard commodities and soft commodities.
Hard commodities
Natural resources like metal ores, oil reserves, and other resources make up hard commodities. They serve as the cornerstone of a nation’s economic health, and by tracking worldwide demand for these resources, one may predict an economy’s long-term stability. It’s because the items’ fixed nature makes their supply and demand essentially predictable.
Soft commodities
Soft commodities are goods that require cultivation and maintenance, such as agricultural products, livestock, and related basic goods. Since their price-setting system is dependent on a number of outside factors, they are more volatile. The environmental circumstances of a nation have a significant impact on the creation of such commodities. Because of things like climate change, agricultural economies suffer more than urban ones.
How to invest in commodities
These are 3 ways to invest in commodities.
Futures contracts
Investors can trade commodities in the futures market. A commodity is traded at a predetermined price in the future under a commodity futures contract. Futures trading entails speculation and calls for familiarity with commodities. As a result, it might not be a good strategy for inexperienced investors. Institutional producers and consumers make up the majority of market participants in futures.
Commodity exchange-traded funds (ETF)
Commodity ETFs are a good choice to trade commodities. Retail investors can access commodity investments quite easily in this way. Depending on the fund’s concentration, commodity funds can be invested in a wide range of commodities, including energy, precious metals, and raw materials. Others make corporate investments. Commodity ETFs are traded on the stock exchange alongside common stocks and are related to the production of commodities.
Commodity stocks
Another way to access commodities is to buy stocks of commodities-related companies such as oil stocks, gold mining stocks or agricultural stocks. This is an easy and indirect way to invest in commodities. However, the risk is stock prices are influenced by the operations of companies rather than the change in the price of the commodity itself.
Advantage and Disadvantage of commodities investing
Advantage
- Protection against inflation
- Protection against economic risks
- High degree of leverage
- Diversify investment
Disadvantage
- High volatility
- Price inelastic
- Low return on a short-term investment
Advantage of commodities investing
- Protection against inflation
When there is inflation, the price of stocks may decrease. On the other hand, the price of the commodities needed to produce the finished goods may increase exponentially due to increased demand. As a result, the final product price will eventually rise as well.
Therefore, investors move to commodity futures to protect their capital from the effects of inflation and maintain their value.
- Protection against economic risks
When there are economic troubles such as conflicts, riots, and wars, it makes gathering and transportation of raw materials to be processed into finished incidents problematic. Then, leading to a shortage of resources.
In such a case, the supply of raw materials is disrupted, resulting in a mismatch between demand and supply, causing commodity prices to rise exponentially.
- High degree of leverage
Commodity derivatives, such as futures and options, offer an extremely high level of leverage. As a result, using leverage in commodity trading creates the possibility of massive returns.
- Diversify investment
Commodities react to fundamental factors that affect commodity supply and demand, such as weather, wars, and political instability. On the other hand, stocks or bonds do not react to such factors, causing commodity prices to be inconsistent with stock prices.
This negative or low correlation with stocks makes commodities an attractive investment to achieve diversification in a portfolio.
Disadvantage of commodities investing
- High volatility
Commodity prices are highly volatile and are influenced by factors that affect supply and demand such as unfavorable natural disasters or irregular rainfall. The prices of these commodities can be significantly impacted by these factors. As a result, financial instruments based on commodities are highly volatile. This makes commodities highly vulnerable to abnormal events.
- Price inelastic
Price inelasticity is the situation where the supply of the good is unaffected by changes in price or supply; for example it takes a long time to increase commodity production by cultivating new crops, extracting natural gas from the ground, extracting iron from deposits of iron ores, etc.
Consequently, the combination of inelastic supply and demand creates a situation in which a small change in the underlying dynamics of the market can result in significant price fluctuations.
- Low return on a short-term investment
The extreme volatility indicates that this asset class experiences frequent periods of boom and bust, which provides profitable opportunities for long-term traders and speculators. While volatility is low, stocks produce better and more outsized returns compared to commodities.
Popular commodities
The following are some of the most popular commodities:
- Precious metals (gold, silver, platinum, etc.)
- Oil
- Natural gas
- Corn
- Wheat
- Soybeans
- Cattle
- Hogs
- Lumber
Consequently, it’s critical to concentrate on the distinct aspects that are driving each commodity when you’re looking for investments in them. For instance, if gold is rising, it can be as a result of a variety of different supply and demand issues unrelated to; for examples, hogs or natural gas.
Conclusion
Commodity investing helps diversify your portfolio, but many 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. Also keep in mind that price increases are frequently transient, thus commodities might not be the best long-term investments.
Related Article:
Read more: Commodities
Source: Investopedia, Yahoo