When one thinks of the buying and selling of commodities, visions of gold prospectors, farmers, and oil companies might come to mind. While direct involvement in producing and selling the commodity is one way to be involved in this world, there are other avenues for individuals to invest in commodities. Read on to learn how commodities can fit into your investment portfolio and bring in profit.
What is a Commodity?
A commodity is a raw material that is either used directly or serves as an input into making a finished good or product. Some examples include oil, corn, or precious metals.
What makes it a commodity is that the quality is more or less the same, meaning that consumers generally do not pay too much attention to the company responsible for manufacturing and/or selling the product. Think about your experience in the supermarket, where most consumers tend not to pay too close attention to the brand of produce they are purchasing.
The price of commodities is generally set by supply and demand, making most manufacturers price takers (i.e. they must accept the market prices). As an example, the price of wheat rose dramatically in the months following the outbreak of fighting between Russia and Ukraine in 2022, as global supply was hindered by the conflict between these two large grain producing nations.
For this reason, investing in this space is often speculative, and can be fairly volatile (see below).
Different Types of Commodity Investing
There are a number of different types of commodity investing, ranging from direct involvement in the manufacturing to purchasing an Exchange Traded Fund (also known as an ETF) or mutual fund with a focus on a specific commodity.
For most investors, the idea of managing the buying and selling of a commodity directly is well beyond their means, interest, or desire. (Do you really want to be responsible for the physical shipment, storage, and selling of 100 cattle?) Still, it is always an option to buy gold or other precious metals and keep them in a safe deposit box (or under your floorboards).
Short of engaging in directly importing, exporting, or owning physical commodities, one can invest in an ETF or mutual fund that is focused on a particular industry. For example, there are ETFs that track the price of physical gold, other funds that invest in various grains and agricultural products, and mutual funds that purchase shares in energy companies. Many of these funds engage in the purchase of futures contracts, which is an agreement to buy or sell a commodity at a specific price at a pre-determined date.
Another option is to invest in companies whose fortunes are directly tied to those of specific commodities. Oil companies, jewelry producing firms, and agricultural producers are all dependent on the price of crude, precious metals, and farm outputs, respectively. If you have a prediction regarding the rise or fall of the underlying commodities, buying or selling these companies could make sense for you.
What are Some Popular Commodities to Invest In?
Among the more popular commodities to invest in are precious metals such as gold and silver, oil and gas, and other base metals used in large-scale manufacturing such as iron ore and aluminum.
Gold plays a large part in many portfolios, as it has traditionally served as a relatively strong store of value as well as a hedge against inflation (see below).
With the advent of smartphones, lithium has become an increasingly important commodity, as most smartphone batteries contain this metal. Cobalt, on the other hand, is used in rechargeable battery electrodes, which could play a central role in powering a greener future.
In short, there are many different options to choose from.
Can Commodities Be Hedges Against Inflation?
Commodities are often considered hedges against inflation, for the simple reason that rising prices across the board will drive the cost of commodities up as well.
Inflation is the economy-wide rise in prices from one year to the next. In some cases, inflation can even be caused by rising commodity prices, which is known as cost-push inflation. The other type of inflation is caused by rising consumer demand, which drives prices up. This is known as demand-pull inflation.
Investments are considered inflation hedges if they keep their value when the purchasing power of currencies are falling. For instance, a 12-month Certificate of Deposit with a 5% return during a year with 6% inflation will effectively lose money.
The idea that commodities will keep pace with inflation is based on the premise that the cost of these real-world assets will also increase when the overall price of goods and services rises. This, of course, is contingent on the presumption that these price increases do not drive down demand.
What are the Risks of Commodity Investing?
There are a number of risks involved with commodity investing, first and foremost being the volatility involved.
For example, global instability–or even localized conflicts–can have a large impact on the health of commodity investments. Additionally, agricultural producers are particularly dependent on the weather, while policy changes and technological advancements can make entire industries more expensive and less profitable.
In short, diversification–always a smart move when it comes to investing–holds particular importance for those involved in commodity investing. Placing the majority of your holdings in one particular industry can backfire spectacularly, leaving you with catastrophic losses for your portfolio.
Conclusion: Commodities and Your Portfolio
Investing in commodities can serve as a useful method to grow your portfolio. There are number of different avenues to do so, from holding onto the assets directly to investing in companies who use these inputs in their products.
The risks, however, are significant, and it can be especially foolhardy to be too heavily invested in one particular commodity. Still, having some portion of your portfolio invested in commodities can help you hedge against inflation and losses elsewhere.
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