Why Is It Risky To Invest In A Commodity?

Trading commodities is an ancient practice and one still very much in use today. In its simplest form, commodity trading is driven by supply and demand. But is it risky to invest in a commodity?

Why Is It Risky To Invest In A Commodity?

We’ll take a look at the types of commodities and whether you should consider investing in them. 

Types Of Commodities

Commodities are items such as food, metal and energy sources that are traded between producers and buyers. They differ from other trading items in that they have a homogeneity that other items do not have. 

This means that there is no differentiation between the same commodity from different producers. This is achieved by utilizing certain minimum standards or grades. While these can change from year to year, once in place they remain the same. 

So what kind of items can be traded as commodities? There are four main categories.

Metals

Precious metals such as gold, platinum, silver and copper are some of the commodities that are traded. They are also one of the few investments that can be physically owned and traded in their raw form or as finished products. 

Metals are a reliable source of investment and have a real and conveyable value. For the risk-adverse, metals may be a good investment, as they can be a hedge against inflation and currency devaluation.

Investors favor metals when there is uncertainty in the markets or when there is a bear market. 

Energy

Energy as a commodity is one of the best known. Trading in crude oil, natural gas and gasoline is something most people are aware of, as are the fluctuations in their prices.

Oil and gas production can be affected by many factors, and investment should be carefully evaluated. War, terrorist activity and economic downturns all have the potential to hit energy production, and supply, causing problems for investors. 

Climate change and the push for cleaner energy sources is also having an effect on the potential benefit of investing in traditional energy products. 

Agriculture

Agriculture commodities are basically food stuffs like corn, sugar and wheat as well as other raw materials, such as cotton. This is one of the commodity types that are traded using futures, where a price is agreed upon in advance of the commodity being available. 

As there is so much room for disruption to foodstuff production such as the weather, political situations and population growth, it is a more risky commodity group than something like metals. 

Volatility in agricultural commodities is often seen in times of bad weather, unexpected drought or other unforeseen events, making it risky for new or inexperienced investors.

Livestock & Meat

Some typical meat and livestock commodities are pork bellies, lean hogs and cattle. There are several factors that will affect the price of these commodities, such as the number of available live animals, weather patterns and consumer demand. 

The price of animal feed will also influence the eventual price of the live animal or meat, and the impact of disease on the livestock market can be devastating. Manipulation of supply can also affect the prices of these commodities.

Substitute goods can also influence prices, if there is a lack of one type of meat, the cost of a substitute will rise accordingly. 

Why Invest In Commodities?

Many people prefer to deal with physical items when it comes to investing, rather than in stocks and bonds, which are seen as less tangible.

As physical items, commodities are more of a short term investment, while stocks are betting on the long term health of a company. 

The basic principle of supply and demand which drives commodity trading can be affected by a multitude of factors, which can be either global or local. Many are beyond human control, such as the weather, so in this sense investing in commodities is risky.

However, a precious metal such as gold (see also ‘How Much Gold Should You Have In Your Portfolio?‘) will be a reliable investment when other areas of the market are fluctuating, and this can provide portfolio stability. 

How To Invest In Commodities

How To Invest In Commodities

If you are thinking of investing in commodities, but you are unsure how it works, there are a few ways to go about it. 

Invest In Commodities Using Futures

A futures contract is a legal agreement between a buyer and a seller to purchase a commodity at a predetermined price in the future. If the price rises the buyer gets the commodity at below market value, if it falls the seller makes a profit. 

While there is always risk, using futures to invest in commodities can result in large profits, and it is possible to take long or short positions on futures contracts. 

Invest In Commodities Using Stocks

Using stocks to invest in commodities means you are not trading the physical item itself, by investing in a company that trades in that commodity. An example would be buying stocks in an oil company or a copper mining company. 

Stocks are potentially easier to buy, trade and monitor and less susceptible to volatility in the price of futures contracts.

Using ETFs & ETNs To Invest In Commodities

Exchange traded funds (ETFs) or exchange traded notes are similar to stocks in that they allow investors to follow price fluctuations of commodities, but they don’t usually require a brokerage account. 

Although, not every commodity will have ETFs or ETNs associated with them. 

Are Commodities Worth The Risk?

Deciding to invest in commodities will take some thought, research and analysis to better understand the risk versus the reward. There are a wide range of commodities to choose from and while all have risk attached, some are more risky than others. 

Metals are the recourse for those who are protecting themselves in times of market volatility and currency devaluation.

Energy as a commodity is affected by global events and behavior patterns, while livestock and agricultural commodities are at greatest risk of unpredictable weather. 

However, risk is an inherent part of any investment strategy. If unsure, seek the help of a broker to guide you. 

If you enjoyed this article, you might enjoy our post on ‘Best Laptop For Stock Trading‘.

Luke Baldwin