April 23, 2012

Many investors purchase commodities based on speculation about how prices will change. Prices can go through great swings, and investors can very quickly gain or lose large sums of money in volatile markets.

Commodities are raw materials, such as wheat, oil, precious metals and oranges, that can be bought and sold in bulk. Buying on margin and purchasing futures and options while betting on changes in the market make for great risk and, for some, great profit.

oil barrels

In addition to the possibility of making large profits, commodities are sometimes used as a hedge against inflation. Commodities are not closely coordinated with stocks and bonds. This means that if the market for stocks and bonds is down, investment in commodities may still generate profits.

Is it a good idea for the average investor to get into commodities? Those without the necessary expertise and the disposition and wherewithal to risk significant losses should be cautious about this investment. If you do invest in commodities, many financial advisors recommend that commodities not exceed 5 percent or 10 percent of your portfolio.

From a long-term perspective, investing in commodities may make sense because the demand for energy, food and precious metals from the developing economies, such as China, India and Brazil, is likely to increase over time. World population is expected to grow to 9 billion by 2050, which means the demand for food should increase – people have to eat.

However, for any given short period, prices can be affected by events that are not always foreseeable. Political upheaval in oil-producing nations and the drop in Japan’s industrial production after the earthquake and tsunami are examples of unforeseeable events that can affect prices for commodities. While the demand for food may be more or less steady, perishable commodities are affected by weather, so there may be an oversupply or undersupply during any given year.

The average investor may not wish to risk significant sums that can be greatly affected by unforeseeable events and volatility driven by speculation about matters such as whether China’s economy will slow down or the “Arab Spring” will endanger oil supplies. The French investment bank Natixis predicts there will be even more volatility and perhaps bubbles in commodities in the near future because of excess liquidity in financial markets.

If you do want to invest in commodities, what are the ways in which you can do it? One way is to invest in futures and options associated with them. You can purchase on margin, which creates leverage that can lead to profits.

A downside is that leverage can also lead to losses. If prices drop, you may be subject to margin calls.

The futures market can be very volatile, sometimes changing so fast that you lose your money before you have time to close out your position. The average investor should be cautious about getting involved in futures without expert knowledge or advice.

Investing in companies associated with commodities is another way to invest in commodities. Stock prices tend to be less volatile than the futures market.

However, these are not direct bets on commodities, and an individual company’s share price may be affected by company-specific factors rather than just commodity prices. An investor should do appropriate research and get advice if considering investing in particular commodities-related companies.

Exchange-traded funds (ETFs) and exchange-traded notes (ETNs) are also ways to invest. Not all commodities have ETFs or ETNs. Commodity ETFs usually are tied to the price of commodities or a group of commodities that comprise an index. ETNs are unsecured debt that mimics the fluctuations in commodity prices and carries with it the credit risk of the issuer.

Commodities, as a small part of a balanced portfolio, may be a good idea. However, the average investor should proceed with caution.

This article was originally posted on April 23, 2012 and the information may no longer be current. For questions, please contact GRF CPAs & Advisors at marketing@grfcpa.com.