Adroitin Consulting Services: How to Invest in Commodities

Commodities are raw materials used to make other products. These range from agricultural (wheat, corn, soy) to metals (gold, silver, copper) to energy (crude, natural gas, heating oil) and more. Importantly, commodities are standardized across producers with the use of minimum quality standards, called basic grades. This allows them to be interchangeable and grants each type of commodity a value that can fluctuate with the movements of the global market.^[1] Commodities investing is the way in which investors, from individuals to large banks, can make money trading commodities and commodity securities by taking advantage of these movements. This article provides a simple overview of the complex world of commodities investing.

Part 1 Getting Ready to Invest

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Determine how much money you are ready to invest. The commodities market is a very risky place to invest your money, with potentially large gains balanced by equally large potential losses; ; commodities should therefore be a portion of your long-term holdings. Investing in commodities is safest as a part of a large and diversified portfolio that also includes other forms of investments.^[2]
- Commodities can actually reduce overall risk as a part of a diversified portfolio because their movements often are uncorrelated with the fluctuations of other types of securities.^[3]
- Before you invest in commodities, it is recommended that you first get involved in the more elementary areas of investing in the stock market. See how to Invest in the Stock Market for more information.
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Open a brokerage account. In order to trade any securities, including commodities-based ones, you will need the help of a stockbroker to establish an account in which to hold and trade such securities. A brokerage account will allow you to deposit money that can then be invested in securities on your behalf by the brokerage firm.^[4]
- Note that this is not the case if you are planning on simply investing in physical commodities. For example, you can simply buy and store gold on your own as an investment, without entering the securities market at all. However, it is not realistic for most investors to take delivery of larger or more perishable commodities like oil or wheat, this may be more difficult. Investing in securities instead will spare you costs of shipping and storage that can be incurred while trading physical commodities.
- As with any investment plan, first make sure you have enough saved in your emergency fund (3-6 months of expenses) for unexpected costs, such as job loss, illness, injury, etc. Also set aside in cash any amount needed for upcoming planned short-term expenses (automobile purchase, down-payment on a home, for example) in the next 1, 3 or even 5 years.
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Deposit money into your brokerage account. Be conservative with your first commodities investment; there's no need to put large sums of money into a market unknown to you. It's best to gradually build up your position in the commodities market, as this lowers risk.^[5] Alternately, you can sell off shares of stock of mutual funds that you already own to finance your commodity investment.

Part 2

Determining What Types of Securities or Commodities to Buy

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Get advice. Determine if you would like to do your own research or hire someone to help you. Following and understanding the commodities market can be (and is for many) a full-time job requiring knowledge and expertise. If you do not have the time or inclination, hire a financial advisor to help you.
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Invest in physical commodities. The simplest way to invest in commodities is to just buy the actual item itself and hope that the price increases. This introduces the additional costs of storage and shipping that come with holding a physical asset. This is generally only done with precious metals, like gold or silver, because they are smaller relative to their value. These metals are bought in sold both in coin and bullion form.^[6]
- One way to reduce your costs in trading physical precious metals is to use a remote gold dealing and storage. Several bullion firms offer online trading and safe storage of precious metals. If you're unsure of the legitimacy of a bullion firm, always check the World Gold Council's website first.^[7]
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Invest in commodity futures. Commodities have traditionally been traded in the futures market. Futures, which allow an investor to trade contracts to buy or sell a commodity at a set date for a set price, carry a large amount of risk. Because these securities are often highly leveraged (paid for using borrowed money to increase earning potential), a small change in the price of the commodity can result in massive losses (sometimes even more than your initial deposit) or massive gains. In many cases, commodity futures trading is best left to professional traders and large corporations.^[8]
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Invest in commodity-related stocks. Buying stocks to related to certain commodities is a way to bet on the value of a commodity without incurring all of the risk of futures trading. For example, if you want to invest in oil, you could buy stock in companies that drill, search for, transport, or sell oil. However, be advised that these stocks, while correlated with commodity prices, may not move directly with them. For example, if the commodity price jumps 10%, this does not necessarily mean that the related stock price will also jump 10%.^[9]
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Invest in exchange traded funds. Exchange traded funds (or ETF's) are funds with shares that trade like stocks, allowing investors to easily buy into a more diversified portfolio of other securities.^[10] In the case of commodities, ETF's are generally comprised of futures contracts that track the value of a commodity. This allows the investor to invest directly in fluctuations of the commodity price without the risk of actually holding futures contracts. ^[11]
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Invest in mutual funds or index funds. Mutual funds cannot invest directly in commodities future, but can hold a variety of commodity-related stocks. This is basically just like investing in a large number of commodity-related stocks yourself, except for the fact that the mutual fund is professionally managed. Additionally, some index funds invest in commodities futures. This allows for a mutual fund-type approach with more exposure to actual commodity prices.^[12]

Part 3 Diversifying Your Portfolio

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Maintain a balanced allocation of assets. That is, don't put all of your eggs in one basket. You can reduce your risk of losing money by spreading your commodities investments over a variety of different commodities and commodity-related securities.
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Don't hold too much of your money in commodities. In general, investors are advised to only have about 5-10% of their total assets invested in commodities.^[13] Any more introduces your portfolio to unnecessary risk that can be reduced by staying in safer areas of the market.
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Rebalance your portfolio periodically. While many attempt to time the market, research shows that this approach is rarely successful over the long-term. Instead, examine your allocation 1-2 times per year to determine if rebalancing is warranted. That is, sell from those holdings which have a gain and buy shares of those which have lost value. Doing so, achieves selling high and buying low as well as keeping your portfolio in balance.