Why is it risky to invest in commodities?

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Investors and savers are always looking for new ways to maximize their growth potential. But there’s one form of trading that’s been in existence long before the stock market was thought up: commodity trading.

Even in ancient civilizations, commodities— raw materials that help societies function— were traded between populations. The Egyptians, for example, traded gold, linen and papyrus in exchange for cedar wood, stone and incense. Romans imported a diversity of materials like beef, corn, iron, olive oil and silk from its wide network of trading partners.

Today, however, commodity trading is a little bit different, often taking place on a commodity-specific exchange market, like the London Metal Exchange in Great Britain.

But, as with all investments, investing in and trading commodities does come with risk. Because commodities are often traded on futures contracts, they carry some unique characteristics that don’t hold for most other stock market assets.

This article will explain how commodity trading works, what futures are, how much risk is involved and offer some options for getting involved with commodity trading— or any investment strategy —as safely as possible.

Related: Investment risks and ways to manage

What are Commodities?

Commodities are basic items like food, energy sources and metals that can be traded between producers and buyers. They are often the inputs, or raw materials, from which more complicated products are made.

Commodities are differentiated from other items by the fact that they’re basically interchangeable— that is, commodities should not vary significantly in quality or characteristics from one producer to another.

One way this homogeneity is achieved is by the use of certain minimum standards, or basis grades, for the commodities traded on exchanges. Basis grades may change from year to year, but once in place, all traded commodities must meet them.

Examples of commodities include:

  • Metals, like gold, silver, platinum and copper
  • Petroleum products, like oil and natural gas
  • Meat, like beef and pork
  • Grains and other agricultural products, like corn, wheat, rice, coffee, cocoa, cotton and sugar

Technological advances have arguably added other commodities, such as internet bandwidth and cell phone minutes. Foreign currencies, indexes and other financial products are also sometimes considered commodities.

Commodity Risk

Why is it risky to invest in a commodity?

Unlike other stock market assets, commodities are generally traded on futures markets. Futures are pre-arranged agreements between traders who promise to buy or sell a given commodity for a specific price at a specific time in the future, hence the name.

Futures offer both the buyer and seller the opportunity to earn money if the conditions are right. If the overall value of a commodity rises, the buyer makes money because they get it at the agreed-upon price, which may be lower than market value.

If the value of the commodity falls, the seller makes money because they’re still selling the commodity at the agreed-upon price, which is likely higher than market value.

However, because commodity prices are so volatile, changing on a weekly and sometimes even daily basis, futures trading is highly risky to both parties involved.

Whether buyer or seller, in many cases, one trading party is going to lose money on the deal, although the set price of futures does allow traders some level of guarantee as to how much the seller or producer stands to lose.

For instance, let’s say a farmer negotiates a futures contract to sell her harvest of wheat. The buyer agrees to buy a specified amount of wheat at a specific price point.

If the value of wheat has risen by the time the farmer plows her fields, the buyer will be getting a good deal since he’s paying the price they’d already agreed upon, which was negotiated based on the value of the wheat at the time of the negotiation. The buyer can then turn around and sell the wheat at a higher price, earning a profit.

On the other hand, if the value of wheat has fallen by the time the farmer sets out to harvest her yield, she is spared financial devastation by the guaranteed price bottom.

Rather than losing out on her profits entirely, she’ll earn whatever the agreed-upon price was, which was, again, based on the value of the wheat at the time the contract was negotiated, which is more than the wheat is currently worth.

Why Invest in Commodities?

Given the risk involved with investing in commodities, what motivates investors to trade them?

For one thing, investing in commodities gives investors the opportunity to diversify their portfolio with a whole new class of assets, one that generally performs in opposition to the stock market itself —that is, when the stock market is bearish, commodities tend to increase in value.

Furthermore, diversification is generally a good risk management tactic. Investing in commodities is a good way to round out a portfolio packed with more traditional investments like stocks and bonds.

Commodities do also have some characteristics that give them a unique advantage in the world of investments. Because they’re exchanged on futures contracts, there’s a guaranteed sale price and date. The sales may not be as profitable as capital gains made by shareholders, but that kind of stability is hard to find elsewhere on the market.

Benefits of investing in commodities include:

  • A guaranteed price bottom, which keeps sellers from overwhelming losses and buyers from massively overpaying for a commodity that may have lost value.
  • The security of knowing exactly when a sale will be made and how much will be made on it, which is not offered by stocks and takes longer to come to fruition with bonds.
  • A good potential for growth and profit since the value of commodities is so volatile, price increases can lead to significant earnings.

However, none of these benefits negates the risks involved with investing in or trading commodities, although risk is inherent in any investment choice.

Stock Market Risks

While commodity risk is a factor when considering investing in commodity futures, it’s important to understand that all investments carry risk. For instance, stocks can gain and lose value as the companies that issue them perform well or poorly. It is always a possibility to lose all of the money put into a stock market investment in the case of a serious market decline or recession.

Of course, some market volatility is totally normal and even healthy. And while nobody can predict the market perfectly, some tendencies do historically hold.

For instance, while there’s no direct correlation between interest rates and stock market performance, in the past, when interest rates go up, stock market performance tends to decline. That’s because companies, like individuals, can be priced out of taking loans they need for the continued growth and performance of their businesses. This may mean they have less money left over to reinvest or count as profit.

The reality of risk is no reason to forego investing entirely, as investing is still one of the most powerful ways to grow wealth.

And during major global crises, like the recent outbreak of the novel coronavirus, markets can sometimes experience major turbulence and downturns.

The reality of risk is no reason to forego investing entirely, as investing is still one of the most powerful ways to grow wealth.

The power of compound interest means even small contributions can grow to an appreciable sum over the course of time. The average market return of the S&P 500, an index, which measures 505 of the largest companies on the U.S. exchange, is about 8% accounting for performance between 1957 and 2018. That figure rises to 10-11% if performance back to the index’s inception in 1926 is brought in.

As a beginning investor, you’ll have to spend some time assessing your personal risk tolerance, which will vary depending on your financial landscape and goals. For instance, if an investor has major obligations like children to provide for or debt to pay down, they may be able to afford less risk in their investments than others.

But there are also ways to manage and mitigate investment risks, including thoroughly researching prospective assets before purchasing them, seeking the help of a trained wealth management professional, and diversifying a portfolio.

How Diversification Helps Mitigate Investment Risk

Diversification is a term that’s thrown around in the investment space often. But what exactly does it mean— and how does it help investors mitigate the inherent risks involved with investing?

Diversification means maintaining a wide variety of different asset types and classes— stocks, bonds, commodities and other asset classes, for example— and also ensuring the investments kept within a given class come from different companies and industries.

That way, if (and when) market volatility comes calling, investors will have their eggs in a variety of baskets, which can mitigate the risk of losing everything if a single sector has a major problem.

Keeping a diverse portfolio can mean investing in stocks from a wide range of different companies with different attributes.

For instance, investors might choose small-cap, mid-cap or large-cap stocks, which define companies based on the overall value of their market capitalization (the total cash value of the outstanding stock the company has on the market). Investors may also choose to invest in companies from different industries, such as technology, renewable energy, communication or healthcare.

Along with including a multiplicity of company and stock types, investors can also pad out their portfolios with additional asset types, like government bonds or, you guessed it, commodities.

Because these assets sometimes perform in opposition to the market, they can be a good way to balance stock investments.

One easy way to get a lot of diversification with a relatively small amount of effort is to invest in ETFs and mutual funds.

Diversifying with ETFs and Mutual Funds

ETFs, or exchange-traded funds, and mutual funds are slightly different, but they operate in largely the same way. They’re pre-curated baskets of assets, like stocks and bonds, that allow the investor to purchase a small piece of a wide swath of the market with a single buy.

ETFs can be bought and sold just like shares of stock, and they may track a well-known existing index like the S&P 500. (There is, in fact, an ETF that tracks this index, whose stock ticker is SPY.)

ETFs can contain a range of different asset types, including commodities as well as stocks and bonds, and generally offer low expense ratios since they may not be actively managed and don’t require as many trade or brokerage fees as going in and purchasing each of those assets individually.

Mutual funds are similar to ETFs in their diversity of assets, but unlike ETFs, mutual funds are only bought and sold once per day, at the end of trading. Mutual funds are also often actively managed by a third party, which may offer some comfort to investors. However, they tend to carry a higher expense ratio than would be found on a similar ETF.

More from SoFi

This article originally appeared on  SoFi.com and was syndicated by MediaFeed.org.

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