Any savvy investor knows you can't put all your eggs in one basket. Even though it may not cut out risk entirely, diversifying your investment portfolio can help you reach your investment goals by maximizing your returns.
There are plenty of different investment vehicles for you to choose from including stocks, bonds, mutual funds, futures, and currencies. These can be broken down even further, grouping together assets that share characteristics: large-cap stocks, financials, and government bonds are just a few examples.
And don't forget commodities. These are basic goods that can be transformed into other goods and services. There are a number of different commodity investments for both new and experienced traders. But before you head out to make the leap, here are a few important things you need to know about commodity investing, including the best ones to consider.
- Investing in commodities can provide investors with diversification, a hedge against inflation, and excess positive returns.
- Investors may experience volatility when their investments track a single commodity or one sector of the economy.
- Supply, demand, and geopolitics all affect commodity prices.
- Investors can trade commodity-based futures, stocks, ETFs, or mutual funds, or they can hold physical commodities such as gold bullion.
- Three of the most commonly traded commodities include oil, gold, and base metals.
How to Invest in Commodities
You can invest in oil, gold, or base metals by buying individual stocks, exchange-trading funds (ETFs), or mutual funds that focus on those sectors. But there are other ways to go:
- Oil futures are a favorite of day traders and are bought and sold through brokerages that specialize in futures trading. This is volatile stuff and not for the faint of heart.
- Gold investors can purchase bars, coins, or jewelry, and stash them in a safety deposit box.
- Base metals like aluminum, zinc, and copper are valuable only in huge quantities. The best way to invest in them is through the stocks of producers like Alcoa and U.S. Steel, or through ETFs.
What Is Commodity Investing?
Commodity trading goes back centuries, even before stocks and bonds exchanged hands. It was a very important business, linking different cultures and people. From spices and silks in the early days to the exchanges where these assets are now traded, commodities are still popular investment vehicles.
Investors hoping to get into the commodity market can do so in several different ways. Commodity-hungry investors can consider investing directly in the physical commodity, or indirectly by purchasing shares in commodity companies, mutual funds, or exchange traded funds (ETFs).
One of the biggest benefits of investing in commodities is the fact that they tend to protect investors against the effects of inflation. Generally, demand for commodities tends to be high during periods of high inflation, which pushes up prices. It's also a good bet against the U.S. dollar; so when the greenback declines, commodity prices rise.
Aside from the benefits of diversification, there is the potential to maximize returns with commodity investing. Although commodity prices are subject to fluctuations in the market through exchange rates, interest rates, and the global economy, global demand is strong. This has an overall positive impact on the stocks of companies that deal specifically with commodities, which can translate to positive returns for investors.
One thing to keep in mind is that commodities tend to be much more volatile than other kinds of investments, especially funds that track a single commodity or a specific sector of the economy.
Investors who trade futures should remember that it involves speculation. Futures contracts involve tracking an underlying commodity or index. This could have an impact on the performance of the contract and thus give the investor a negative (or positive) difference.
Futures also come with their own set of unique risks that must be managed independently of the underlying commodity.
Protect against inflation
Diversify a portfolio
Hedge against a decline in the base currency
Help hedge price risk
Increased volatility when compared to other investments
Margin trading in commodities potentially resulting in significant losses
Speculative nature of trading with uncertainty of the outcome
If you have crude oil in mind, it helps to know what shapes prices and how you can invest in this commodity. After production, crude oil is refined into many different products, including gasoline that is used to fuel vehicles. But it goes beyond just gas. Products made from petroleum include plastics, medicines, linoleum, shingles, ink, cosmetics, synthetic fibers, solvents, fertilizer, asphalt, and thousands of others.
But what affects prices? Crude oil generally reacts to the laws of supply and demand. When demand exceeds supply, prices tend to rise. When demand wanes and supply remains fairly consistent, prices tend to fall. For instance, when gas is in high demand—say, during the summer driving season—the price at the pumps rises, translating into higher crude oil prices.
Similarly, demand from developing nations such as China and India—whose economies are still growing—is also pushing up prices. Geopolitics also has a big impact on the price of crude oil. Tensions in the Middle East, where much of the world's oil is produced, can send oil prices skyrocketing.
Oil prices were once greatly influenced by the producer cartel OPEC, made up mainly of Middle-East countries. In the early 21st century, the development of new technology, particularly hydro-fracturing (fracking), created a second U.S. energy boom, largely decreasing OPEC's importance and influence. Today, the U.S. is the largest net producer of crude oil in the world.
How to Invest in Crude Oil
Investing in physical crude oil isn't as easy as investing in other commodities; you can't just buy a barrel of oil. As an investor, you may consider futures; the most direct method of owning the commodity outright. But futures can be highly volatile and need a good deal of capital. And they also require a great deal of knowledge, so it's not really a good option for novice investors.
Investors may consider purchasing stocks in oil companies, crude oil mutual funds, or even ETFs. These vehicles trade on exchanges just like stocks, so they're easy to come by. The U.S. Oil Fund is one example. It tracks the movement of West Texas Intermediate light, sweet crude oil.
Other options include buying shares in mutual funds or energy sector ETFs, which invest directly in oil company stocks. These options tend to come with lower risks because they have more diversified offerings.
The gold market boasts diversity and growth. It's used in jewelry, technology, by central banks, and investors, giving rise to its market at different times within the global economy. The precious metal has traditionally been a safe investment and a hedge against inflation. When the U.S. dollar goes down, you can bet gold prices will go up.
Just like crude oil, when there's an increase in demand, the same happens to the price of gold. Furthermore, prices are affected when central banks—which hold gold—decide to diversify their monetary reserves by buying more gold.
How to Invest in Gold
Unlike crude oil, investors can take possession of the physical commodity. Investors who want to hold the physical commodity can do so by purchasing gold bullion bars or coins. But this means having to pay to store it in a deposit box, vault, or another safe place.
Another option, just as you would for crude, is to go through the futures contract. Contracts require investors to deposit an initial margin. But again, there is a risk to this kind of investment. If the price rises, investors will profit; however, if the price drops, the investor stands to lose their money.
Stocks and ETFs, along with mutual fund options are plenty. With gold stocks, investors aren't just limited to producers but also to exploration and mining companies. As usual, it's a good idea for investors to do their homework and see what the operational risks are for each company.
Gold ETFs, on the other hand, provide exposure to the precious metal while tracking its price. For instance, the SPDR Gold Shares ETF gives investors exposure to bullion without having to take possession of it.
Silver often trades similarly to gold, but with a gold/silver price ratio that fluctuates over time.
Base metals are common metals used in commercial and industrial applications, such as construction and manufacturing. Aluminum, zinc, and copper are good examples. They are relatively inexpensive, and supplies are generally stable because they're commonly found around the world.
But because they are plentiful, prices tend to be much lower than they are for precious metals; however, the increase in the applications of base metals coupled with rising global demand—particularly from China and other developing nations—continues to positively impact prices.
How to Invest in Base Metals
Holding on to aluminum, zinc, and copper may not necessarily be very fruitful. Because of their low prices, investors would have to hold copious amounts of these commodities in order to profit.
Instead, holding stocks in base metals companies like aluminum company Alcoa or a steel company like U.S. Steel is a great way to get a foot in the door. Furthermore, holding ETFs like the SPDR S&P Metals & Mining ETF provides exposure to companies involved in metals and mining.
What Is the Best Way to Invest in Commodities?
The best way to invest in commodities is through commodity ETFs. ETFs allow for ease of trading because they are purchased like stocks, provide diversification, are not traded on margin like futures are, and typically have low expense ratios.
When Should You Buy Commodities?
There is no specific time that constitutes the best time to buy commodities. Commodities are a hedge against inflation, so buying before periods of high inflation is a good investment strategy; however, predicting when inflation will occur can be tough.
A commodity should be viewed as any other investment, taking into consideration an investor's time horizon and risk profile. Buying a commodity when it is at a low price and its future outlook appears strong based on fundamentals is always a good time to buy for a long-term horizon.
How Do I Buy Oil Commodities?
An individual can buy oil commodities by either purchasing an oil commodity ETF, buying the shares of oil companies, or buying oil futures through a brokerage account.
Are Commodities a Good Investment?
Like any good investment, commodities can also come with risks. An investor needs to understand the markets of the commodity in which they wish to trade—for example, the fact that oil prices can fluctuate based on the political climate in the Middle East.
The type of investment also matters; ETFs provide more diversification and lower risks whereas futures are more speculative and the risks are higher because of margin requirements. That being said, commodities can hedge against inflation, and gold, in particular, can hedge against a market downturn.
How Do I Start Commodities Trading?
You can start trading commodities by opening a brokerage account and purchasing shares in the commodity-specific company of your choice or a commodity ETF after you have done your research and determined the specific investments that are right for you.
The Bottom Line
Like any investment, commodities come with their own risks but can still be a great way to diversify your portfolio if you understand the various aspects of the commodity in which you choose to invest.
In addition to the commodities mentioned above, other commodities to consider are other precious metals—platinum, palladium, silver—lithium, cotton, and food products such as coffee, corn, oats, wheat, soybeans, and sugar. But as with all investment decisions, do your research or consult with an experienced broker.