Commodities Investing for Beginners

December 8, 2021

Stocks and bonds are common components of most investment portfolios. Of course, alternative investors know that there’s a whole world of investments out there just waiting to be tapped.

But even alternative investors often overlook commodities. And if you’re serious about investment diversification, it might be time to add this type of asset to your portfolio.

Here’s a breakdown of commodities investing for beginners, including all the basics you need to get started with this exciting asset class.

What is Commodities Investing?

Commodities are primary products, such as raw materials, which are traded on specialized exchanges. Each commodity is generally interchangeable with a commodity of the same type, so when someone buys a commodity, they know what they’re purchasing and generally have a good idea of what it’s worth.

For investors, commodities are a useful diversification tool. Like other alternative assets, they have little correlation to the stock market (and often move opposite the stock market). For this reason, many investors rely on commodities when the stock market is volatile, and depending on the commodity, they may use it as a rescue asset.

Types of Commodities

Generally, commodities are divided into four broad categories:

  1. Metal
  2. Energy
  3. Livestock and meat
  4. Agricultural

Metal commodities include things like gold, silver, platinum, and copper. Some investors opt to use precious metals as a value store, particularly during a bear market.

Energy commodities include things like crude oil, gasoline, heating oil, and natural gas. Unlike the metal market, the energy sector is highly susceptible to economic ups and downs, and new technological advances toward clean energy may change the value of such commodities in years to come.

Livestock and meat commodities are exactly what they sound like—livestock, including things like live cattle, feeder cattle, lean hogs, and pork bellies.

Similarly, agricultural commodities include pretty much any agricultural product, including corn, wheat, rice, soybeans, coffee, and sugar, to name just a few. Keep in mind that the value of these commodities is often subject to the season and any major weather transitions. That said, the combination of population growth and limited agricultural land supply means this can be a valuable area to invest in.

Unique Market Characteristics

Few types of investment assets are as subject to the laws of supply and demand as the commodities market.

Remember, you’re investing in primary products—physical things that consumers buy. That means that commodities are subject to the ebbs and flows of supply and demand, and often the whims of nature and chance.

For example, let’s say you own livestock commodities in one way or another. As a whole, there’s a predictable demand for livestock, so investors can usually count on consumers to buy these products. However, if there were a widespread cattle disease impacting the supply chain, otherwise stable prices would spike and create a ripple effect in an otherwise stable supply and demand chain.

The Rules of Commodities Investing

There are two broad rules of commodities investing:

  1. Lowest price wins
  2. Price spikes are usually short-lived

In the commodities market, companies are price-takers, which means the company that produces at the lowest cost generates the most profit per unit. As long as the market stays open, they have a wide profit margin, and they can continue to thrive.

Conversely, the least stable companies are those who produce at high costs. Any market volatility can leave the company unable to sustain production, and if the industry doesn’t turn around soon enough for the company to recover, the company is likely to fold.

As you can guess, price spikes are the greatest fear of commodity investors. Prices tend to hover around an equilibrium point in the long-run, but in the short-run, they can be extremely volatile. As with stocks, this often means that investors and markets overcorrect when they should have stuck to their investment.

How to Invest in Commodities

Thinking of getting started in commodities investing? Here’s the good news: you have lots of options to get started.

The most obvious avenue is to invest in physical commodities. However, there are certain commodities where that isn’t advisable or desired (things like pigs, oil, or cattle herds, for instance). Generally, when investors opt for physical commodities, they tend to reach for precious metals as a rescue asset and inflation hedge.

If you want to ride the benefits of the commodities market without owning physical commodities, commodities stocks are the simplest way to get started. Again, look for companies that produce at the lowest cost (and thus have the highest profit margin).

If you’d like to get more diversification than you would get from commodities, commodities exchange-traded funds (ETFs) offer a simple way to do that. Some of these ETFs are indexes of commodity producers. Some invest in commodities directly. Some even invest in commodities futures. Either way, you get immediate diversification with the benefit of being able to sell your ETF shares just like you would sell a stock.

For experienced investors, another option is to invest in commodities by way of futures contracts, a legal agreement to buy or sell a specific commodity asset or security at a predetermined price at a specified date in the future. This is actually the best-known way to invest in commodities, though we recommend it only for experienced investors as it isn’t the simplest investment avenue. They’re also high-risk, high-reward, and should only be used by investors with a high risk tolerance who can afford to weather a potential loss.

Ready to Get Started in Alternative Investing?

For the savvy alternative investor, commodities investing offers a handy way to branch into a different asset class with unique benefits. And for those who want their portfolios to weather economic ups and downs, that’s essential.

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