Amidst a sea of red in the stock market and high inflation, many investors are looking toward investing in commodities such as gold as an alternative.
And if you are reading this article, chances are that you are too.
Ask any savvy investor, and they will tell you that the key to investing is to build a diversified portfolio.
And while investing in commodities can help you do just that, it is important to know what you are investing in (as always).
So here’s an in-depth beginner’s guide to investing in commodities, encompassing all you need to know about the commodity market and how you can invest in them.
Disclaimer: The information provided by Seedly serves as an educational piece and is not intended to be personalised investment advice. āReaders should always do their own due diligence and consider their financial goals before investing in any investment product.
TL;DR: Should You Invest in Commodities?
Commodities are inherently risky investments as they areĀ largely affected by demand and supply.
The individual markets are affected based on their own highly specific industry conditions, which can be difficult or impossible to predict (extreme weather conditions affecting crop supply for example).
For:
- Useful investment tool as a stock market and inflation hedge (if you invest and not speculate)
- Helps build a diversified and resilient portfolio when investing in stable commodities (ie. gold)
Against:
- High price volatility can make it extremely risky and speculative in the short-term
- Margin trading can result in significant losses
- In-depth knowledge required when dealing with specific commodity markets
What Are Commodities?
Since centuries ago, commodities have been traded even before stocks were a thing.
Commodities refer to raw materials and can be classified into:
- Agricultural products: including corn, wheat, and cotton.
- Livestock and meat: including beef, chicken and milk.
- Energy products: including crude oil, coal, and natural gas.
- Metals: including gold, silver and nickel.
The Commodities Market
Like the S&P 500, the commodity market also has indexes such as the S&P Goldman Sachs Commodity Index (GSCI) that track the performance of the 24 commodities from all commodity sectors in the market.
As can be seen in the above graph, commodities tend to be uncorrelated to the stock market – which makes them a great diversification tool for retail investors like you and me.
However, commodity prices can fluctuate wildly and are very unpredictable.
Thus, we need to understand what influences such price swings.
Factors Affecting The Price of Commodities
1) Demand and Supply
Since commodities such as oil, chicken and wheat are used to provide for our basic necessities such as food, prices trend upwards whenever there is a shortage in supply.
The most recent example would be the decrease in oil supply caused by the invasion of Ukraine by Russia on 24 February 2022.
Coupled with inflation since the start of the year, you can see from the chart that oil prices spiked after the invasion before continuing to trend upwards to above US$120 per barrel.
As Russia accounts for roughly five million barrels of oil a day, second only to Saudi Arabia, the supply of oil has been greatly reduced, driving prices upwards.
On the flip side, a big harvest of a certain crop would push prices down.
2) Weather
Other factors such as weather can also affect the supply of commodities. Droughts for example could severely limit the supply of wheat and drive prices up.
3) Politics
Moreover, politics can come into play when a country decides to restrict its import or export of a certain commodity.
Many Different Commodities
That said, there are many different commodities and while each commodity is largely affected by demand and supply, the individual markets are affected based on their own highly specific industry conditions.
Yet, some commodities are relatively stable such as gold, to the point that it serves as an asset for central banks.
As a result, investing in a specific commodity requires extensive knowledge of that specific market.
Benefits of Commodities Investing
A Stock Market and Inflation Hedge
As mentioned earlier, commodities can be used as a hedge against a drawdown in the stock market since their prices have a low correlation to it.
Moreover, commodities tend to have a high correlation with inflation and can be used as a hedge against high inflation as well.
Building a Resilient Portfolio
If you’re looking for a safe-haven investment, investing in stable commodities could also help you build a more resilient portfolio in times of inflation and crises.
Risks of Commodities Investing
But before you start investing in commodities, you’ll also need to understand the risks.
High Price Volatility
Commodities are a much more volatile investment than most, especially when you only invest in one commodity or an index that tracks a specific sector.
Margin Trading Can Result in Significant Losses
If you choose to trade futures, you need to remember that it involves speculation and is extremely risky.
Futures also come with their own separate set of risks, which include the risks of trading on margin (borrowing money to trade).
How to Invest in Commodities
1) Commodity Stocks
One way for retail investors is to invest indirectly by purchasing shares of a company that produces commodities.
Think the likes of Shell PLC (LON: SHEL).
When investing in commodity companies such as Shell which produces oil, the company usually benefits when the prices of oil go up. However, the reverse is also true.
Like stocks investing, you’ll also need to do your own research and find out things like how much oil reserves it has and whether the company can sustain itself in the long run.
2) Commodity ETFs and Mutual Funds
With the volatility of commodity prices, one good way to reduce your risk exposure would be to invest in commodity ETFs or mutual funds.
These funds may invest in physical commodities, commodity stocks and/or future contracts.
If you want to include a broad exposure to gold in your portfolio, for example, you could consider the SPDR Gold Trust ETF (NYSE: GLD).
As for those who are bullish about oil, you may consider the United States Oil Fund LPĀ (NYSE: USO).
For broad exposure to commodities in general, investors can buy shares of the iShares S&P Commodity-Indexed TrustĀ (NYSE: GSG) which tracks the S&P GSCI.
3) Investing Directly in Commodities
Unless you own chickens, most retail investors in Singapore will find it hard to directly own commodities like livestock. You’ll have to handle logistics such as the storage of the commodity and finding a dealer to trade with.
However, some commodities like gold are much more accessible and you can buy them in Singapore through local dealers.
4) Trade Futures Contracts
The last way that you can ‘invest’ in commodities is to trade futures contracts, so long as you have a brokerage account that allows it.
However, this is a very speculative move to make as you will need to do margin trading.
For the uninitiated, trading on margin means that you are trading borrowed money, which can amplify your losses.
Should You Invest in Commodities?
For the average retail investor, investing in commodities can diversify your portfolio and cushion the impact of inflation and a bearish stock market.
This usually means investing in broad exposure commodity ETFs or commodity stocks.
Other than that, trading commodities or futures contracts are generally not recommended unless you are an experienced investor and have enough capital to cover potential losses.
Trading commodities involve timing the market which is akin to speculation.
Would you be investing in commodities? Share your thoughts on the Seedly Community.
