Introduction to Commodities Investing

Module 4: Understand the Risks in Commodities Investing

Learning Objective:

• Understand risks involved in commodities investing.

Just like investing in stocks, bonds, currencies and cryptocurrencies, there are risks involved in commodities investing. In order to improve your chances of success, you need to have a firm understanding of whatever it is you are investing your hard-earned money into.

Investing into anything you do not understand is a sure way to increase your level of stress. Following the advice of an industry leader may feel prudent in the short run, but when the investment does not perform as expected you may be tempted to sell at just the wrong time. An understanding of the fundamentals gives you long-term confidence, and any declines in price may be viewed as buying opportunities rather than times of doubt and confusion.

Before pulling the trigger on an investment, seek to understand both sides of the argument: Both for and against. People tend to have a bias to seek out information that agrees with their initial decision. Talk to people you trust and respect, and do not dismiss opposing viewpoints too quickly.

With all that said, below are detailed several of the most common risks of investing in commodities.

Leverage

There are many stories of how investors lost a fortune in commodities. The question that needs to be asked, though, is, “How leveraged were these investors?” Futures markets offer a high degree of leverage. For example, a commodity trader may only have to post 5 to 15 percent of the contract value in margin to control the total value of the contract. This means that small movements in the price of the commodity could result in huge swings in the value of the futures contract in relation to the initial investment. Highly leveraged investments can quickly result in big profits or big losses!

Macroeconomic Factors

The commodities industry can be significantly affected by world events, import controls, worldwide competition, government regulations, and economic conditions. All of these factors, and more, can have an impact, positive or negative, on commodity prices.

Volatility

Commodities investments can quickly become more volatile than traditional investments, such as stocks. The amount of volatility can vary depending on the concentration and make-up of your particular investment. For example, some mutual funds or exchange-traded products (ETPs) may track a single commodity, while others track a more diversified basket of commodities. Understand what you are putting your money into. If you have done your research and feel confident in your analysis for a longer-term investment, short-term fluctuations in price based on superficial factors that do not affect your fundamental long-term analysis should typically be of no concern.

Foreign and Emerging Market Exposure

In addition to the other risks of commodities investing, many commodity prices are heavily influenced by the risks that come with investing in emerging markets. These risks include, but are not limited to, volatility caused by political, economic, and currency instability.

Asset Concentration

Once again, make sure you understand the make-up of your investment. Typically, the more diversified an investment fund, the less volatile it will be. Should a single commodity or company experience a drastic price change in a concentrated fund, the value of the fund will be significantly impacted. Whereas this impact would not be quite as severe in a more diversified fund. Diversification should be considered not just across commodity types, but also across categories (agriculture, energy, metals, livestock), asset classes (commodity stocks vs. physical commodities), and even time-horizons.

Other Risks

Commodity funds may use futures contracts to track an underlying commodity or commodity index. These securities can be very volatile and should not be expected to exactly match the performance of the underlying commodity’s spot price. In fact, the performance of the fund may significantly differ from that of the spot price. Before investing in a fund, research the fund’s make-up, historical performance, and how long the current managers have been operating the fund.

Take Action

Different commodities will carry different specific risks. Continuing with your chosen commodity from previous modules, spend time researching and understanding the risks involved in investing in your commodity. Look for examples of how your chosen commodity can be negatively affected by unforeseen events, such as weather patterns, strikes, government regulation etc. The more you understand about your commodity, the better chance you have of identifying potential threats to your investment. Long-term success in investing, regardless of asset class, requires homework on your part. But what better motivation do you need than the prospect of making money!