When you first start researching investments, you will run across terms that seem like a foreign language. If you’ve ever wondered, “What are commodities?” or, “What is a security?” you’re not alone.
There are several major investment classes, including stocks, bonds, real estate, commodities, and more. Learning the different investment terms will help you speak the investing language and inform your overall investment approach
What are commodities?
Commodities are products that come from or are sustained by the earth. This includes farm animals and agricultural crops such as corn, wheat, soybeans, cotton, cattle, and more. In addition, products of mining such as copper, aluminum, silver, gold, coal, natural gas, and oil are also considered commodities.
Same-grade commodities are considered interchangeable (or fungible in investment terms) no matter who produced them. For example, a bushel of soybeans from farm A in Iowa is considered the same as a bushel of soybeans from farm B in Ohio as long as they are an identical grade and quality.
If you’re looking to buy soybeans to feed your cattle, you don’t care if it comes from farm A in Iowa or farm B in Ohio, as long as they are the same grade.
Unlike currency or stocks, commodities are concrete products that can be used and consumed by those who buy them. For example, an airline may lock in the price of fuel with a futures contract to avoid market volatility if crude oil and gas prices.
Farmers also may lock prices for their crops with a futures contract before they plant them to get a guaranteed return on investment for the work they do. If the price of the crops declines before harvest season, farmers can still get paid based on the futures contract they secured.
Investors who buy and sell commodities are not necessarily looking to use or claim the physical commodity. They may use futures contract to buy and sell commodities on exchanges based on speculation.
This more advanced practice is not appropriate for the average investor. Before investing in commodity futures, check that the individual and firm are registered with the National Futures Association (NFA) by going here.
Commodities vs. securities
While commodities refer to tangible products, securities refer to intangible ownership. Examples of securities include company stocks and government and corporate bonds.
You can hold physical products such as corn or oranges in your hand. When it comes to securities, your ownership is virtual. You cannot touch a company share or a corporate bond (unless you have a physical paper certificate to go along with it).
Both commodities and securities are traded, but that’s the only thing they have in common. Commodities are created (or mined), sold, and consumed. Securities represent ownership of a part of a company or debt obligation. They can be secured (backed by collateral) or unsecured.
The two main types are equity security and debt security. There are also hybrid securities, but for this explanation, we’ll stick with the main two.
When you buy an equity security, you get ownership interest in a publicly traded company, such as General Electric. You make your money when you sell the security provided it increases in value. Some equity securities pay out dividends as well.
The other type of security is a debt obligation in the form of a bond, CD (certificate of deposit) or collateralized security. When a company or a government entity wants to raise money for something, they can use debt securities to borrow money similar to a loan.
For example, if a county hospital wants to raise funds for a new building, it may take out a loan by issuing bonds. The bonds will stipulate the terms of the loan, the interest rate, and maturity or renewal date.
The hospital can use the proceeds from the bond sales to pay for a new building and pay back the loan over time.
Advantages of investing in commodities
While commodities investing is not for everyone, there are certainly some advantages that draw investors to this asset class. For those who know how to leverage them, commodities can offer a good option for increasing portfolio returns.
Advantages of commodity investing:
Diversification: Since commodities are a different asset class than securities, they can offer portfolio diversification for investors. This can help manage market volatility but doesn’t protect against loss or guarantee a profit.
Returns: Commodity prices can go up and down because of supply and demand, inflation, the overall health of the economy, and so on. When the demand increases, it tends to drive prices up, increasing returns.
Hedge against inflation: Inflation has a different effect on stocks and bonds than on commodities. While it can erode the value of securities, it can increase prices for commodities. This can mean strong returns in a period of high inflation, but you still need to watch out for volatility.
Risks of investing in commodities
Investing in commodities is not for the beginning or even more advanced investors. There are many risks associated with this type of investment. You take a big chance that your investment could lose value.
Risks to consider when investing in commodities:
Principal risk: When you invest in commodities, there is a very real risk that your investment can lose part or all of its value. Commodity prices are volatile and affected by world events, worldwide competition, regulations, economic conditions, and much more.
Volatility: Commodity ETFs that track a single commodity or sector can be much more volatile than their security counterparts. In addition, futures, options, and other derivatives can put your investments at further risk.
Asset concentration: Since commodities and commodity ETFs are concentrated heavily in one industry or sector, they are considered non-diversified. This means that any changes in the market value for a particular sector or commodity may have a much bigger impact on your investment than in a more diversified fund.
Price of raw materials: It’s not unusual for the price of a raw commodity to double, triple, or be cut in half—all in a very short amount of time. Since commodities are so volatile, you can easily lose a lot of money quickly. Stocks and bonds tend to have lower fluctuations, making them more appropriate for the average investor.
The federal agency that regulates futures trading is called the U.S. Commodity Futures Trading Commission (CFTC). Since commodities investors are common targets of fraud, the CFTC cautions against offers for high-yield investment opportunities in futures, options, or foreign exchange.
What are commodities ETFs?
There are two ways to buy and sell commodities: through futures markets and through exchange-traded funds (ETFs). A commodity ETF invests in physical commodities such as crops, precious metals, or natural resources.
ETFs can either be invested in the physical storage of a specific commodity or in futures contracts. Some ETFs track the performance of a commodity index that combines the two.
A commodity ETF is like a bucket filled with asset-backed contracts rather than the physical goods. These funds usually track their own category of products such as metals, natural resources, agricultural goods, and so on.
Select commodity ETFs track a diversified basket of commodities rather than a specific category such as agricultural goods. Popular commodity ETFs are precious metals such as silver and gold, and oil and natural gas.
Precious metal commodity ETFs have the advantage of investing in a commodity such as gold and silver that can’t go bad. This is popular with investors looking to diversify but not wanting to invest in futures contracts directly.
The majority of commodities are traded on commodities exchanges such as the New York Mercantile Exchange (NYMEX) and the Chicago Board of Trade (CBOT).
Since investing in commodities can be risky, ETFs can offer a middle ground. They offer an exposure to commodities while minimizing the risk associated with trading futures contracts.
How to get government commodities
Government commodities investing usually looks a little different. It may include investing in water rights such as access to water from clean sources like lakes and rivers.
Once you have the water, you can charge companies and local governments to access the water covered in your investment contract. Keep in mind that land and water rights are regulated by the government on the local, state, and federal levels. This can make the process more complicated.
The bottom line
Commodities are one of the major investment classes along with securities. Since they represent physical products, they offer a different type of investment risk than stocks and bonds.
Prices for commodities can fluctuate greatly depending on political conditions, world events, and weather conditions. This makes them very volatile and not appropriate for the majority of investors.
The best strategy for the average investor is a low-fee, diversified mix of assets such as Wealthsimple Invest. Investments with more risk, such as commodities or individual stocks, should represent a very small portion of your portfolio—and only invovlfunds you’re willing to lose.
Ready to diversify your portfolio? Check out Wealthsimple Invest for a low-fee way to minimize risk and maximize returns. We help you build an intelligent portfolio based on your risk tolerance. Get started today in just a few minutes.
