Commodities are much more popular now than ever, and they are being used to protect the buying power of the investor’s capital. Let’s demystify these commodities and see how you can include them in your investment portfolio.
Commodities are products that are generally uniform in quality and utility wherever they come from. For example, consumers buy a bag of wheat flour in the supermarket without paying much attention to where they were milled.
They are interchangeable, meaning a whole bunch of products whose brands people don’t care about can be considered commodities.
Meanwhile, a much more precise view is taken by investors.
Hard and Soft Commodities
Hard commodities are those that require mining or drilling to find. This category includes metals like gold, copper, and aluminum, as well as energy products that include crude oil, natural gas, and unleaded gasoline.
On the flip side, soft commodities are those that are grown or ranched. This category includes corn, soybeans, wheat, and even cattle.
The S&P GSCI Total Return Index
Benchmarking your portfolio’s performance is extremely important for you to gauge your risk tolerance and expectations for return. On top of that, benchmarking offers a basis for comparison of your portfolio performance with the rest of the market.
Among commodities, the S&P GSCI Total Return Index is seen by investors as a broad commodity index. That’s true even for futures contracts for commodities that include oil, wheat, corn, live cattle, gold, and aluminum.
This index is production-weighted, and it is based on the importance of each commodity in the global economy or commodities that are produced in greater quantities. That means it is a more suitable index of their value in the markets place. This works in a similar fashion with the market-cap weighted indexes for equities.
Overall, this index is treated as more representative of the commodity market when compared to other similar indexes.
The changes in the prices of commodities are all dependent on the supply and demand dynamics. For instance, where a big harvest of a crop takes place, the price usually goes down. On the other hand, when a drought happens, prices rise because of fears that future supplies will be smaller than expected.
In a similar manner, cold weathers push up the prices of natural gas for heating. A warm spell during the winter drags down prices, however.
And because the dynamics of the supply and demand sides change often, the volatility found in commodities is usually higher than those for bonds, stocks, and other types of assets. There are commodities that are more stable than others, like gold, which also happens to be a reserve asset for central banks to buffer against volatility.
That being said, gold also experiences period of volatility. Other commodities usually switch between stable and volatile depending on market conditions.
How to Invest in Commodities
In general, you can invest in commodities in four ways:
- Investing directly
- Using commodity futures contracts to invest
- Buying some shares of exchange traded funds, or ETFs, that invest in different commodities
- Buying some shares or stocks of a company that has something to do with commodities