Commodities are physical goods, such as livestock or precious metals, that can be used as-is or to make other goods. They have become a more mainstream investment since the turn of the century, and it can make sense to allocate part of your long-term investment portfolio to them if you know what to expect.
- You can invest in commodities directly, through mutual funds and ETFs, or with futures.
- Investors use commodities for growth potential, diversification, and inflation hedging.
- The risks of commodities include high levels of volatility, especially when using complex instruments like futures contracts.
Basics of Commodities in a Portfolio
The most important thing to remember when considering commodities in your portfolio is that there is a big difference between investing in them and speculating in them.
Some investors feel that you have to open a commodity account and trade futures contracts if you want to invest in commodities; that was the traditional path until a wide range of different financial commodity investments came on the market. In reality, opening a commodity trading account with no trading experience or plan is more akin to speculation, not investing, unless you intend to learn how to trade properly and consistently make money. It often takes a significant amount of time, money, and effort to do that. Until that status is achieved, only money you can afford to lose—not money you depend on—should be used for self-directed commodities trading.
In contrast, when you invest in commodities, you generally include them as one asset in a long-term portfolio you intend to use for a goal, such as future income or appreciation to help you fund your retirement. Through this approach, you would allocate a certain percentage of your overall portfolio to commodities. An investor can, for example, choose to allocate 5% to 15% of his investment portfolio in commodities, but he should choose commodities that will still be around in 20 to 30 years.
You can invest in commodities in a few ways:
- Invest directly in commodities. This approach requires you to buy and acquire the goods.
- Invest in mutual funds. Another way to get exposure to commodities is to buy commodity mutual funds that comprise the stock of firms that deal with specific commodities.
- Invest in futures contracts or exchange-traded funds (ETFs). This involves trading futures contracts (agreements to trade a commodity for a set price at a certain date in the future) or ETFs that correlate with commodities or commodity indexes. This approach can be the most volatile unless you use a professional to trade managed futures on your behalf through a managed commodity account.
If you're an inexperienced commodities investor, only risk capital you can afford to lose in a self-directed commodity trading account.
Benefits of Adding Commodities to Your Portfolio
A commodities portfolio comes with the following advantages:
- Aggressive growth prospects: The price of commodities often goes up as demand increases and down as supply increases. Depending on market conditions, a commodities portfolio may reward you with higher returns than you could have achieved through a traditional asset allocation of stocks and bonds.
- Diversification: Commodity prices are influenced largely by supply and demand, which means they won't necessarily move in tandem with the stock market. In addition, goods can't go bankrupt like companies. Having a portion of your portfolio in commodities versus entirely in stocks and bonds allows you to hedge against sharp declines in the stock market.
- Inflation: A commodities portfolio may help you weather inflation without the same losses as a traditional portfolio of stocks and bonds. Commodities have in the past performed well during inflationary periods even as stocks and bonds have lost value.
Risks of a Commodities Portfolio
For all their benefits, investing in commodities comes with certain risks:
- Market fluctuations. Commodities are regarded as more volatile than other investments because their prices are dictated by supply and demand. The volatility of commodities may also mean that when you lose money, you lose a substantial amount.
- Less exposure across industries. Whereas a traditional mutual may comprise securities spanning a wide range of industries, a commodity fund may contain less diverse securities that only give you exposure to a few industries.
- Increased risk of futures contracts. When you invest in futures contracts that correlate with commodities or related indexes, there's no guarantee that the investment will perform well just because the commodity is in demand. This is why opening a commodity account and trading futures contracts on your own with no trading experience is only advisable if investing capital you can afford to lose. It should not be part of a strategy for building a retirement portfolio you are depending on for future income.
Options for Financial Commodity Investments
Consider these investments to gain exposure to commodities in your portfolio.
Managed futures that let you trade in the futures market through a money manager are probably one of the best ways to invest in the commodity market. Your money is usually placed in a separate managed commodity account that is managed by professionals who typically invest in a diversified number of commodities that can earn a decent return over a period of years. They're typically not correlated with other investments like the stock market, and this offers a strong degree of diversification to an investment portfolio.
Managed futures fund managers are often guided by a trend-following investment approach. This is an excellent way to catch large movements in commodity prices, whether they're up or down. Some investors even diversify within different futures funds in their managed commodity accounts. For example, it may make sense to invest in a trend-following fund and a fund that trades the ranges in commodities.
Another way to invest in commodities is through commodity ETFs. There are a wide variety of ETFs that invest in diversified commodities or business that deal with these commodities. Some only invest in a single commodity and others invest in a particular commodity sector.
You can tailor your investment to whatever commodities make sense for you. It's best to try for a widely diversified group when you're choosing commodity ETFs for a long-term investment. One of the more popular commodity investments over the years has been commodity stocks. Gold-mining stocks are among the favorite investments in the commodities arena.
The Bottom Line
Commodities can help diversify a long-term investment portfolio and may increase your returns if you recognize the difference between speculation and investments and understand the rewards and risks.
Opening a commodity trading account without trading experience or a plan should be considered speculation, and only risk capital should be used in such a strategy. In contrast, investors seeking long-term growth should seek to allocate a percentage of their portfolio to financial commodity investments that will still be around a few decades from now. In addition, investing in managed commodity funds through managed commodity accounts affords the opportunity to gain exposure to commodities at less risk than performing commodities trading on your own.