Investors who are looking for an opportunity to expand their portfolios may consider investing in commodities. The term "commodity" refers to any raw material or agricultural product that can be bought and sold, including orange juice, coffee, lumber, oil, livestock and metals such as aluminum or copper. You can invest in the commodities market by purchasing futures of stock shares or by investing in exchange-traded funds (ETFs), index funds or mutual funds. Commodities investing has become increasingly popular in recent years; however, there are several pros and cons you should consider before adding them to your portfolio.
Pro 1: Hedge Against Inflation
One of the primary advantages associated with investing in commodities is that they act as a barrier against inflation. Inflation occurs when there is a steady increase in the price of goods and services which typically corresponds to a decrease in the purchasing power of money. Inflation can be triggered by an imbalance in supply and demand or be the result of companies' increasing prices to reflect an increase in their production costs. When the economy is going through a period of inflation, the government may opt to increase interest rates, which can in turn have a negative affect on the prices of stocks and bonds. If your portfolio is comprised primarily of these types of investments, an extended period of inflation can potentially eat into your bottom line and reduce your overall profit.
With a commodity, inflation can actually have the opposite effect. An increase in the prices of goods and services due to inflation can cause the prices of those commodities used to produce those goods and services to increase as well. As prices increase, supply must also be increased in order to keep up with demand, meaning more commodities are needed. As the prices of commodities increase, the overall value of your investment increases correspondingly.
Pro 2: Increased Portfolio Diversity
Another benefit of investing in commodities is that they add diversity to your portfolio. Different types of assets react differently to fluctuations in the market, which can cause the value of your portfolio to increase or decrease over time. For example, when stocks go up in value, bonds tend to go down and vice versa. The same is also true of commodities. In general, as stock prices increase, the price of commodities drops. If you have the majority of your money tied up in one particular type of investment, your portfolio may lose a significant amount of value as the market fluctuates.
The balance of stocks, bonds and mutual funds included in your investment portfolio should reflect the level of risk you're most comfortable with. For example, more conservative investors may tend to favor bonds and mutual funds over individual stocks. By adding commodities into the mix, you're also adding an increased measure of stability which can help to protect your assets against changes in value over the long-term.
Con 1: Market Volatility
While investing in commodities can offer a sense of stability and the potential for big profits, there are certain drawbacks to consider. One of the primary issues associated with commodities is that they are considered to be extremely volatile compared to other types of investments. This means they carry a higher degree of risk. The prices of commodities are tied to supply and demand and these prices can be impacted by conditions and situations that are difficult or impossible to predict such as adverse weather conditions or radical changes in the geopolitical landscape of a particular country.
If there's a substantial amount of speculation about a particular product, this can also cause prices to spike rapidly. For example, the price of orange can increase overnight if a colder than normal winter is predicted. Technological advances can also have an impact on how commodities prices are determined. The introduction of alternative energy sources, including the increasing availability of natural gas, has lead to speculation that the price of crude oil will be affected by a decrease in demand. Commodities are also susceptible to overall fluctuations in the world financial market.
Con 2: Loss Potential
Like any other type of investment vehicle, there is no guarantee that you can make a profit with commodities. The key to success is to buy when prices are low and sell when they increase. Since the prices of commodities are subject to rapid changes, the risk of losing your principal investment is high if you're inexperienced in commodities trading. If you're investing in commodities futures, the risk may be even greater.
Trading in commodities futures means that you agree to buy or sell a specific amount of a commodity at a certain price on a predetermined date. In doing so, you're essentially gambling that the future price of the commodity will be higher or lower. If market changes do not reflect your position at the time the commodity is scheduled to be bought or sold, you can end up losing your principal investment and potentially needing additional capital in order to complete the transaction.
Whether you're new to investing or a seasoned pro, it's important to conduct thorough research before investing heavily in the commodities market. While commodities may be a profitable option in the short-term, they may not be suitable as a long-term investment.