Some investors may praise them, others criticise, however nobody can disagree that commodities have been around for centuries, serving as one of the most popular financial vehicles through the ages. Today, we will find out what they are and whether it is the right time to add commodity investments to your portfolio.
What are commodities?
If you’ve just started your journey in the world of investments, then "commodities" is a term you will likely have come across. But what are commodities? They surround you daily, from the orange juice you drink every morning to the petrol you fuel your car with. Commodities impact the global economy at every level and form the basis of the international market system.
Financially speaking, a commodity is a basic good or a raw material that is usually naturally-occurring or agriculturally grown. Commodities can be traded by both institutions and individuals. Is it as simple as that? Well, not really. In reality, commodities are quite complex as they come in many different shapes and forms, providing individuals with numerous investment opportunities and benefits.
Commodities are mostly used as a basis for the production of more complicated services and goods. That is why they can quickly impact the entire supply chain and the overall performance of an industry in general. Iif there is a shortage of some particular commodity, the further production process will be affected, resulting in the changes in the final price and supply of the product.
There are countless different types of commodities available for investing and trading. Investors usually split commodities into two categories: hard and soft. Hard commodities are known as the natural resources that require extracting, such as gold, copper, crude oil, and natural gas. Soft commodities, on the other hand, refer to things that are grown or ranched, such as corn, wheat, soybeans, and livestock.
One of the greatest properties of commodities is that they have full or substantial fungibility, meaning that they are interchangeable with other commodities of the same type, with no regard to where they were produced or by whom; they are either identical or considerably similar. The quality of a given commodity may differ slightly, but it is essentially uniform across manufacturers. A barrel of oil is always pretty much the same product, regardless of its origins. Additionally, when traded on an exchange, commodities must meet specified minimum standards known as a basis grade, which also helps to maintain the quality of the goods.
The history of commodity trading
It is believed that the first commodity markets were found in Sumer, the world’s oldest civilisation, between 4500 and 4000 BCE. In Sumer, which is now modern-day southern Iraq, citizens used clay tokens sealed in a clay vessel as a medium of exchange for goats. Clay writing tablets represented the number of tokens hidden inside each vessel. The fact that the clay tablets included information regarding the amount, time, and date tells us that they were the earliest form of today’s commodity futures contracts.
There are many similar examples that can be found in other civilisations where pigs, furs, seashells, and other common items were used as commodity money to pay for goods and services in barter.
Over the millennia, traders have continuously improved on that system, eventually leading to the development of the commodity market as we know it today. In 1571, the Royal Exchange in London was established by a merchant in order to found a centre for commerce in the capital. This institution led to the creation of commodity trading companies, including the London Metal Market and Exchange Company, which later formed the London Metal Exchange, a futures exchange with the world's largest market in options and futures contracts on industrial metals. Other notable exchanges that contributed to the evolution of commodity trading include the Chicago Mercantile Exchange, a US commodities derivatives exchange founded in 1874 to offer agricultural commodity trading.
Why add commodities to your investment portfolio
Nowadays, political uncertainty, economic crisis, teetering stock markets, and wobbling bonds and funds mean more and more people take a step toward adding commodity investments to their portfolios.
Investors typically rely on commodities to provide four key benefits to their portfolios: diversification, risk reduction, inflation protection, and return potential. If there’s a possibility that securities seem threatened, commodities typically kick in as a valuable and tangible asset that you can actually have in your possession that is expected to keep its value. After going through the economic roller coaster of the past couple of decades, we’d all like to have a bit more stability in our investments. Besides, the recent growth of commodity markets has been quite impressive.
It is commonly known that the more inverse the correlation between assets, the greater the diversification. That is why investors typically look up to commodities to protect an investment portfolio from extreme volatility. The beauty of commodities as a means of diversification is that they often run counter to other major assets, such as stocks and bonds. When commodities are in a bull market, stocks appear to be in a bear market, and vice versa. The negative correlation between commodities and other assets is a well-established trend that serves well for diversification purposes. However, keep in mind that diversification does not fully ensure against loss.
You may wonder, why do commodities move against stock market? Commodities are major input costs for companies, many of which trade on the stock market. Increase in commodity prices can result in higher costs for the company to manufacture its products. This can weigh on the company’s stock price. Conversely, if commodity prices fall, that same company can probably produce its products cheaper, performing better in the economic arena.
While some may still see commodities as intimidating and risky, even the smallest proportion of these included in your portfolio could lead to a reduction of both volatility and risk. Therefore, commodities can serve as a hedge against loss: when one asset goes down in value, others will offset the loss if they have increased in price. Additionally, lower volatility should improve the consistency of returns over time.
Another reason to invest in commodities is that they offer the possibility of protection against inflation. As prices rise, and goods become more expensive, commodity prices also increase. Then, producers are eager to supply more, resulting in more commodities needed to meet the increased demand for raw goods. With commodities being at the very epicentre of the global supply chain, an investment in this particular market can act as an effective inflation hedge and bring higher potential returns.
Since the stock market is rather unstable, commodity investing can be a great strategy to consider. At the end of the day, whether you like it or not, commodities could provide a much-needed balance to your investment portfolio.
How to diversify your portfolio with commodities
Like the stock market, you can trade and invest in hundreds of commodities through futures, options, exchange-traded funds, contracts for difference, and many other financial instruments. With commodity investments, the choices are endless. If you are interested in learning more about how to invest in commodities, check out the related article and free online courses provided by Capital.com.
Just like any other asset, investing in commodities can give no guarantee of financial success. Nevertheless, they are, in fact, an undoubtedly stable choice for long-term investment, portfolio diversification and an excellent hedge in times of economic vagueness.
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To add or not to add: spicing up your portfolio with commodity investments