Investing Making Your Dollars Work For Your Commodities
Commodity investing is a bit of a mystery to many investors. Commodities are products for which there is a demand, but there is no differentiation of quality across the market. For instance, sugar is sugar. You can’t taste sugar and determine who produced it. The same goes for crude oil. A refining company isn’t overly concerned about the source of its crude oil. It can all be utilized in the same way.
Most commodities are agricultural products and basic resources. Common commodities include coal, electricity, crude oil, salt, tea, soybeans, rice, wheat, gold, silver, and so on.
These might seem like boring investments, but the commodities market is very volatile and is the second-largest investing market in the world after currency trading. It’s anything but boring. This is the type of investment that can keep you up at night.
Why you might consider commodity investments:
1. Performance. Commodity investing has been lackluster since 2010, but it’s beginning to show signs of life again. In 2014, a diversified basket of commodity investments is beating both stocks and bonds.
2. Diversification. Commodities tend not to move in sync with stocks and bonds. However, Commodities can be a great way to balance your portfolio and diffuse some risk.
3. Protection against inflation. When consumer prices spike, commodities tend to increase in value as well. Things will still cost you more, but you’ll likely make money when prices rise, too.
‣ WAYS FOR THE AVERAGE INVESTOR TO INVEST IN COMMODITIES
In the past, commodity investing required a lot of time, money, and knowledge. Fortunately, there are many options
available today that make it possible for the average investor to invest successfully.
Consider these options:
1. Mutual Funds. There are mutual funds and index funds that invest in stocks related to the various commodity industries. Interestingly, most mutual funds cannot legally invest in commodities in the traditional sense, such as buying and selling futures contracts. However, index funds are able to take advantage of these options.
‣ Keep in mind that stock prices are dependent on more than just the price of the underlying commodity.
‣ With this method of investing you will have professional management, as well as good liquidity. Diversification can also be high.
2. Exchange Traded Funds. These are fund shares that trade like stocks, rather than at the net asset value like mutual funds. These funds are able to utilize future contracts and provide direct exposure to the change in the price of the targeted commodity.
‣ Professional money management removes the burden of predicting commodity movements from your shoulders.
3. Merged Futures. It’s possible to pool your money with other investors to invest in commodity futures contracts and options. A commodity pool operator does the actual collection of funds and the investing.
‣ This is a good way to work directly with commodities and still have professional money management.
4. Futures. If you’re bold you can forgo all the professional management and take on the world of commodity futures yourself. A futures contract is simply a promise to either buy or sell a certain amount of a commodity at a given price. You essentially earn or lose the difference between the agreed upon price and the actual price.
‣ For example, if you agree to purchase 5000 bushels of corn at $2.52 per bushel in September, you’ll make out well if the actual price is $4.00 per bushel. Someone else had to agree to sell it to you at that price. You can turn around and sell your corn for $4.00 per bushel.
‣ However, if the price were under $2.52, you would lose money. You would still be forced to purchase the corn at
‣ a higher price. Unless you wanted to take delivery of the corn, you would need to sell it at the current market price, which is lower than your purchase price.
‣ The real power of futures contracts is the leverage. It’s possible to control a lot of resources with a relatively small investment. However, it also creates the possibility of losing a lot of money, too.
‣ COMMODITY PRICING
To invest successfully in commodities, it’s important to understand the factors that influence the prices. These factors are difficult to predict, and that’s the challenge with commodities investing. If you could predict these factors, you’d rapidly become a very wealthy person.
Keep these factors in mind:
1. Demand. It’s basic economics. When demand outstrips the supply, the price rises. Where there is more of the product available than the market demands, the price drops.
2. Weather. Agricultural products are very dependent on weather conditions. A typhoon can have catastrophic effects on the supply of sugar. A drought can limit corn yields. Scarcity results in rising prices.
3. The economy. When the economy is weak, demand for many commodities will drop, driving down the price. The opposite can be true when the economy is strong. Keep in mind that some commodities are more sensitive to economic forces than others. Learn all you can about your specific commodity of interest.
4. Political conditions. Instability in oil producing countries can impact the availability, and hence the price, of oil.
5. Governmental policies. Governments can impose taxes and tariffs on nearly any import or export. This has the effect of changing prices and altering demand. A single move by a government can radically change your investment.
There are other factors, such as currency exchange rates and inflation, but these are the primary drivers of commodity prices.
‣ A WORD TO THE WISE
Investing in commodities can be a great idea, but be careful about
investing directly on your own. The leverage is attractive and can create a fortune quite quickly, but it’s just as easy to lose a lot of money, too.
Remember that you’re often competing directly with seasoned professionals that trade futures for a living. With every transaction, someone wins and someone loses. Are you confident you can compete with a Harvard MBA that does this full-time?
There are other means of investing in commodities with less exposure that also utilizes professional money managers. Commodity investing provides an excellent way to diversify your portfolio. Experts suggest that 5-10% of a portfolio should be in investments that track one or more commodity indices.
It’s important to really specialize in the commodity that interests you if you’re going to invest directly. Attempting to master sugar, gold, and coal is likely to end in disaster. This is the type of investment that requires daily, even hourly, updating. If this doesn’t appeal to you, choose one of the other commodity investment options where you can take advantage of a professional manager.
If you’re not currently in the commodities marketplace, consider joining the fun.