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3. Commodities Investing

Getting Started in Commodities Investing

Commodities investing...you've probably heard that it is very risky and shouldn't be part of your portfolio.

Ironically, commodities investing is somewhat of a lost art. Back when the main driver of the economy was farming, farmers regularly used commodity investing as a way to hedge against price swings.

During autumn, farmers would take their crops into the city in search of buyers.

• If farmers had excess food, they tried to sell as much as possible by lowering prices.
• If the conditions were especially harsh, shortages occurred, which caused prices to skyrocket.

When "futures" markets were created to allow farmers to hedge against price swings, modern commodities investing was born. The markets gave farmers a place to buy and sell their goods at an agreed upon price BEFORE the weather conditions had a chance to impact the harvest.

What are Commodities?

Commodities are and asset class made up of "fungible" raw materials.

The word fungible means that two "goods" (products, materials, etc.) can be interchanged with one another without changing the value. For example, 1 oz. of gold can be interchanged with another 1 oz. of gold (of the same purity) without changing the value.

Source:www.goldalert.com

Commodities fall into several categories:

• Grains
• Corn, oats, wheat, rice, soybeans
• Livestock
• Cattle, hogs, pork bellies
• Food & Fiber
• Lumber, cocoa, coffee, sugar, cotton, orange juice, rubber, wool
• Metals
• Copper, gold, silver, aluminum, tin, platinum, palladium
• Energy
• Crude oil, heating oil, natural gas, gasoline, electricity, nuclear, hydroelectric, wind, solar

This asset class is one of the three main investment instruments traded within the futures market (the two other investments are currencies and financial futures). But you can also gain exposure to commodities without buying actual raw materials by buying shares of mutual funds or exchanges traded funds.

Why Invest in Commodities?

The main reason to invest in commodities is diversification. Commodities, as an asset class, behave differently (in terms of price movement and return on investment) than stocks and bonds.

There is another, less known reason to invest in commodities. Returning to the list above, several type of commodities can also be considered "green investments", such as hydroelectric, wind, and solar energy.

Click here for more information on how you can make green investments from Invest-Safely.com

Advantages

• Commodities can provide diversification
• Historically uncorrelated (the beta calculation does not equal 1) to stocks and bonds
• Limited tax benefits
• Short-term profits are taxed as 40% short-term / 60% long-term)
• Real assets (vs. Financial or Contractual)
• Potential hedge against the loss of purchasing power from inflation, bear markets, recessions, and depressions
• Click here to learn more about the loss of purchasing power and the causes of inflation

Disadvantages

• Increased volatility (compared to other investment instruments)
• Volatility has a direct impact on risk!
• Click here to learn more controlling risk via position sizing
• Some commodity investment vehicles require leverage, further increasing volatility
• Commodity prices are dependent on more factors compared to other asset classes and investment instruments
• Buying real assets creates storage requirements (i.e. COSTS!)

Factors that Affect Commodity Prices

Supply and demand are the main drivers of price, both of which are heavily influenced by global/local politics, economic and social developments, and even weather conditions.

How to Start Commodities Investing

The easiest and most straightforward way to begin investing in commodities is to buy some!

Since commodities are real assets, you can buy them in many different places. Gold and silver (even platinum and palladium) can be bought in the form of coins and bullion bars.

Actually buying physical goods is not practical for all commodities...hold onto 20 hogs for 10 years and see what happens to your yard.

Even going to the gas station and buying a few gallons of gas or a few quarts of oil will still create problems with storage space and spoilage, not to mention trying to sell it!

As an individual investor, there are several other ways for you to get involved in commodities investing.

Individuals can invest in and trade commodities on their own by opening a managed futures account with a financial/investment advisor.

The following link will open a new window and take you to a list of brokers from the the Chicago Board Options Exchange (CBOE).

If you're just starting out, it may be beneficial to join a limited partnership and trade commodities as part of a group. This will limit your risk, and allow you to take advantage of other people's experience (this path is very similar to an investment club - see the number one rule by clicking here).

Many investors want exposure to the commodities markets, but do want to manage the risk and volatility associated with futures investing.

In this case, use more traditional financial assets. Investment firms make investments in commodities, and then sell shares in their mutual and exchange traded funds.

As an individual investor, you can buy shares of a commodities mutual fund, a managed futures mutual fund, or an exchange traded commodities fund.