Commodities are a great way to hedge your portfolio against rising inflation levels since most commodities increase in price as inflation increases. But investing in commodities can be tricky, especially for newer investors looking to diversify their portfolio. Here is our brief rundown of how to invest in commodities.
How To Invest in Commodities and Commodity Sectors
There are several different ways you can invest in commodities. Below are some of the most popular and most recommended ways for beginner investors to break into the commodity market and add it to their investment portfolio.
- Purchasing physical commodities.
An example of owning physical commodities would be purchasing gold, or other precious metals. While this is easily the simplest way to invest in commodities (as in the case of precious metals), it comes with some difficulties. Agricultural commodities (or soft commodities) like livestock or wheat require storage facilities, feed or fertilizers, and other necessities to remain useful.
- Purchasing commodity ETFs that track specific commodities.
Commodity ETFs (exchange traded funds) can track particular assets, making them a great alternative to owning a physical commodity. One thing to note is that commodity ETFs may not always move in sync with the underlying commodity prices of the commodities they hold.
- Purchase commodity stocks.
Another way to invest in commodities is to buy shares in the companies that produce them. It’s important to note that the stock of a commodity-producing company won’t necessarily rise or fall in line with the commodity it produces. With that being said, commodity stocks are a great way to get into commodity investing.
- Invest in commodities futures contracts.
Commodities futures contracts lay out the goods' quantity, quality and delivery terms to ensure the commodity prices for the future. Futures contracts help investors stay protected against commodity price spikes, and you can even invest in ETFs or a mutual fund that track futures contracts prices.
Benefits and Risks of Commodities Investing
Every kind of investment has its advantages and disadvantages, and the commodity market is no different. Below are some advantages and disadvantages to investing in commodities that may help you decide if the commodity market is right for you.
The biggest advantage to investing in commodities is the high level of diversification you can achieve from them. Most commodities aren’t correlated with each other. A single portfolio can hold a variety of hard commodities and soft commodities.
This means you can use different commodities to complement each other in your portfolio. Complementing assets will help transfer volatility between assets as markets and stocks fluctuate. The result is better diversification with less volatility to you, the investor.
Another advantage to including commodities in your portfolio is the potential returns you can make when holding stocks of commodity-producing companies. Commodity markets are run by supply and demand.
When demand for specific commodity increases, the commodity prices will increase as well, this usually (but not always) affects the stock price of the companies that produce these stocks. Recognizing demand trends and patterns will allow you to invest in companies whose stocks are on an upward trend thanks to rising demands – enabling you to make considerable returns in a relatively short time.
- Hedge Against Inflation
Lastly, and easily the most common reason people choose to invest in commodities is the hedge they provide against rising inflation. Unlike most other assets, stock prices tend to increase as inflation increases. Gold and other precious metals been a staple commodity to invest in because of its ability to protect investors from rising prices inflation year after year after year. But gold isn’t the only commodity that benefits from rising prices due to inflation.
Almost every other commodity asset price will increase as inflation increases. Oil, for example, has increased in price exponentially over the last few months due to rising inflation (as well as the conflict in eastern Europe).
Volatility is another disadvantage of commodities. ETFs or mutual funds that track single commodities can bring in higher-than-average volatility, and certain commodities are simply extremely volatile investments.
The price fluctuations and risks associated with commodities can undoubtedly contribute to overall portfolio volatility, as investments could lose value as quickly as they gain it. This also makes commodity investing and trading commodities somewhat challenging for long-term retail investors.
- No dividends
Most investors hold shares in a company because of the dividend payouts companies provide. Unfortunately, when you invest in commodities, dividend payouts are practically nonexistent. While your investment may be growing in value, there’s no way for you to compound on that growth using dividends or the additional income stream that would otherwise be available to you.
How To Balance Commodity Exposure
As with almost any other kind of asset, the key to minimizing risk and over-exposure is balance. An effective strategy to minimize risk when investing in commodities is to balance them with a diversified mix of tangible assets. You could include commodity futures, real estate equities, natural resources stocks, and gold and inflation-sensitive stocks to broaden your range of commodity-related investments.
This strategy would mean you can stay flexible while balancing your commodity investments with the rest of your portfolio.
When learning how to invest in commodities, it’s easy to get overwhelmed with all the information that’s out there. Commodities offer an excellent way for investors to hedge their portfolios against inflation and build a well diversified portfolio.
As part of a well-balanced portfolio, commodities can prove valuable investments. The key is to pick them carefully, be mindful of cost factors involved, and make sure to balance any commodity investments with other real assets.