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Commodities are goods used in commerce. Traditionally, commodities have included goods such as crude oil, gas, grains, metals, or coffee. However, goods such as foreign currencies, internet bandwidth, or even cell phone minutes are now considered commodities as well.
Commodities are popular investments due to the high demand for these goods. However, there are several risks associated with investing in commodities. There are also a few downsides that might not make this type of investment a good addition to your portfolio.
Commodities are not for every investor, but they can yield high returns if you pick lucrative commodities, invest at an opportune time, and follow a strategy that is adapted to this market. It is crucial to educate yourself about commodities if you’re thinking about investing in them.
When you look at a commodities market you need hedgers and speculators. If you don’t have one, you don’t have a market. That’s how it works.
– T. Boone Pickens
From a historical point of view, commodities usually perform very well compared to other investment products. The average return is higher than most investment products and risks are fairly low compared to some markets. However, adopting the wrong approach to commodity investing could have disastrous results for your portfolio.
Most investors choose not to allocate more than 10% of their assets to the commodity market due to high price fluctuations. If you’re a more conservative investor, allocating between 4% and 6% of your assets to this market would most likely be a better option for you.
Investing in commodities for the wrong reasons or at the wrong moment will lead to a loss.
Consider these reasons for including commodities in your investment portfolio:
1. Commodities give you an opportunity to diversify your investments.
If you’re only investing in stocks, you can gain exposure to a different market with commodities.
2. Commodities provide you with a hedge against poor stock market or bond performance.
Historically, commodities tend to be independent from the stock market and negatively correlated to bonds. This means the price of commodities, especially futures contracts, tend to go up whenever bonds lose their value.
3. Commodities make great long-term investments due to the increasing demand.
These are the main factors causing demand to go up in most sectors:
4. Commodities keep you safe from inflation.
If the inflation rate goes up, demand on the commodity market usually goes up, which leads to higher prices. If some of your investments are likely to suffer if inflation goes up, adding commodities to your portfolio is a good way to prevent inflation from negatively affecting your portfolio.
5. Commodities are a safety net.
In case of a natural disaster, financial crisis, or a war, stocks and bonds can quickly lose their value. On the other hand, commodities will retain their value and many even go up.
These are excellent reasons to include commodities as one part of your portfolio. Approaching the commodity market for any other reason could be very risky.
Commodities tend to zig when the equity markets zag.
– Jim Rogers
Even though the commodity market carries some risks, commodities are a very popular investment vehicle.
Consider these advantages of allocating a reasonable percentage of your assets to the commodity market:
1. Returns are potentially high.
As supplies of natural resources diminish, the demand for many commodities increases and prices steadily go up.
2. Commodities could help your portfolio receive steady returns.
If you already have stocks and bonds, you can create a portfolio that yields steady returns by investing in commodities. Whenever your stocks and bonds do not perform well, the commodities you invested in should provide you with the opportunity to yield nice returns.
3. High inflation means the US dollar loses some of its value.
Your stocks and bonds will not be as valuable as before, but more dollars will be needed to import goods from other countries, which will cause your investments in commodities to gain value.
4. Some commodities can bring good returns in a bear market.
If stocks and bonds do not perform well, many individual investors will get rid of them to invest in commodities instead, raising the demand and the price for commodities.
5. Most commodities are not influenced by market movements.
Demand and prices actually go up for commodities such as precious metals in periods of economic uncertainty.
6. Commodities have low risks and low volatility compared to other investment products.
They make a good addition to your portfolio if you need to compensate for other investments that carry high risks.
7. Commodities are very liquid.
You can sell whenever you want to.
8. Lower fees.
Compared to other investments, many commodities transactions carry lower fees and margins.
9. Commodity futures are more transparent than other investment vehicles.
The commodity market is regulated, and the cost of a commodity is the same from one financial institution to another.
10.Less expensive than many investments.
Thanks to online trading platforms, it’s possible to get started with a small initial investment.
The price of a commodity will never go to zero. When you invest in commodities futures, you’re not buying a piece of paper that says you own an intangible piece of company that can go bankrupt.
– Jim Rogers
Take the time to weigh the pros and cons of investing in commodities before deciding if this market is right for you.
These are the downsides of investing in commodities:
1. Returns can be very volatile.
Historically, commodity index funds have actually produced negative returns.
2. Investing in commodities can give you a false sense of security.
Commodities are more tangible than other assets but this does not mean their value cannot drop.
3. Even though commodities carry high potential returns, supply and demand is difficult to foresee.
A natural disaster or unstable political situation in another country could drastically change the market.
4. Speculation is another thing to watch out for.
Some news can cause investors to overreact and lead to high prices that cannot be sustained. For instance, weather predictions can have a high impact on the price of orange juice as a commodity, while a low overall confidence level always leads to higher prices for precious metals.
5. The commodity market can change very quickly, which means you could lose a lot before you have time to react.
Investing in commodity futures means you agree to buying or selling a commodity at a fixed price in the near future. You might end up having to spend more capital than you initially planned if the market changes.
6. Some commodity mutual funds carry high risks because they give you exposure to only one sector.
Avoid assuming that a mutual fund covers enough sectors to provide you with a good diversification strategy.
7. The commodity market can be complex.
It’s important to stay informed and adjust your investment strategy as needed.
8. Irregular income.
Commodities do not provide you with a regular income like financial products with dividends.
These are the main downsides you need to be aware of before you invest in the commodity market. Investing in commodities also carries some risks that need to be properly assessed.
The problem with commodities is that you are betting on what someone else would pay for them in six months. The commodity itself isn’t going to do anything for you….it is an entirely different game to buy a lump of something and hope that somebody else pays you more for that lump two years from now than it is to buy something that you expect to produce income for you over time.
– Warren Buffett
There are three main risks of investing in commodities:
1. Geopolitical risks.
For instance, companies that extract oil in the Middle East have to stay on good terms with foreign governments. International issues regarding access to natural resources are common and foreign governments have kicked companies out before.
Overpaying for a commodity because its perceived value is higher than its actual value is not a sound way to invest your money.
There is a lot of hype on some sectors but very little tangible information.
Gold and silver, like other commodities, have an intrinsic value, which is not arbitrary, but is dependent on their scarcity, the quantity of labour bestowed in procuring them, and the value of the capital employed in the mines which produce them.
– David Ricardo
There are several ways of investing in commodities. If you want to invest in commodities for diversification purposes, it is best to gain exposure to commodities through several investment vehicles.
Purchasing a physical commodity and reselling it later is the simplest way to invest on this market.
These are the advantages of purchasing physical commodities:
There are also some downsides to purchasing physical commodities:
Futures contracts are the most popular way of gaining exposure to the commodity market. Futures are especially popular among investors who want exposure to crude oil, natural oil, grains, cattle, and other similar commodities.
A futures contract is an agreement to purchase or sell a commodity at a specific date at a set price. Most investors who are interested in futures contracts have a commercial use for these commodities and use these contracts to create a hedge in case prices change.
However, individual investors can benefit from futures contracts since prices can change in their favor. Individual investors get out of the contract before the purchase or delivery of the goods is required. Options are often associated with futures contracts to balance fluctuations in prices.
These are the main advantages of adding futures contracts to your portfolio:
These are the downsides:
Stocks do not allow you to directly invest in a commodity, but rather in a company with a value closely connected to the price of a commodity. This approach allows you to gain exposure to a sector on several levels. For example, you can gain exposure to crude oil on different levels by purchasing stocks of a driller, refiner, and tanker company.
Using stocks to gain exposure to commodities is an approach that provides you with a number of advantages:
Besides, there are some downsides to investing in stocks connected to commodities:
Exchange Traded Funds, or ETFs, can track the price of a commodity by investing in futures contracts or by actually storing a commodity.
Exchange Traded Notes, or ETNs, refer to the debt of a company. ETNs can give you exposure to the commodity market if you use this investment vehicle to purchase shares of the debt of a company that extracts or distributes a commodity.
ETFs and ETNs are good investment vehicles for beginners and are traded like stocks, but without the high volatility.
These are the main advantages of investing in ETFs and ETNs:
It’s also important to consider these risks:
Mutual funds give you exposure to the commodity market by investing in stocks of companies directly involved in this market. On the other hand, index funds invest in futures contracts and give you exposure to commodities in a more direct manner.
There are some advantages to using mutual funds or index funds to gain exposure to commodities:
Consider, also, these disadvantages:
Prudence is what makes someone a great commodities trader – the capacity to face reality squarely in the eye without allowing emotion or ego to get in the way. It’s what is needed
by every quarterback or battlefield general.
Commodities are a great way to balance and diversify your portfolio. Ask yourself what asset allocation strategy works best for you. Most investors do not allocate more than 10% of their portfolio to this market.
The main disadvantages of commodities are that prices can fluctuate a lot, sometimes on a very short time-frame, and that the factors influencing prices are very difficult to predict. On the plus side, commodities are always in demand and there are several ways to gain exposure to this market.
Commodities investing requires you to educate yourself about the market and to select the best investment vehicles in view of your goals and willingness to take risks.
A wise strategy when investing in commodities is to use them to diversify your portfolio by investing in different sectors and using different investment products.
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