Introduction to Commodities Investing

Module 4. Managing Risk

Learning Objective:

1. Understand and evaluate the key risks of commodities investing and how to manage them with clarity and confidence.

Introduction: Why Risk Management Matters

Like all forms of investing—whether in stocks, bonds, real estate, or currencies—commodities come with their own set of risks. But risk, when understood and managed, is certainly not something that needs to be feared.

Warren Buffett: “Risk comes from not knowing what you’re doing.”

Many investors lose money not because the asset itself was poor, but because they didn’t fully understand it or responded emotionally when markets turned. This is especially true in commodities, where prices can move sharply in a short period of time. Without preparation, those moves often trigger panic and poor decision-making.

Relying solely on expert advice might feel reassuring in the moment, but when results fall short of expectations, it’s easy to lose confidence and sell at the worst possible time. A firm understanding of the investment—its fundamentals, history, and purpose—gives you the clarity to stay the course. Price declines may become buying opportunities, not moments of fear or confusion.

Effective risk management also means being intellectually honest. Understand arguments both for and against the investment. It is human nature to seek out information that agrees with one’s initial decision or desire. Know the possible downsides before you invest, and do not dismiss opposing viewpoints too quickly.

Knowledge doesn’t remove risk, but it prepares you to manage it. It helps you protect your capital, make better decisions, and avoid emotional mistakes. When others are uncertain, you will have the clarity and confidence to act with decisiveness.

What follows is a detailed breakdown of several of the most common risks of investing in commodities.

Leverage: A Double-Edged Sword

There are stories of investors losing a fortune in the commodities market. The key question that needs to be asked, though, is, “How leveraged were these investors?”

Futures markets, a common tool in commodities investing, offer significant leverage. This means you can control a large position with a relatively small amount of money—sometimes just 5-15% of the contract value.

While this can amplify gains, it can just as easily magnify losses. For example, a 5% move in the price of the commodity could translate into a 50% swing in the investment with 10x leverage.

If you're new to leverage, proceed with caution. You can also gain commodity exposure through ETFs, which often do not use leverage, and may be more suitable for long-term investors.

Volatility: Understand It, Don’t Fear It

Commodity prices are often more volatile than traditional investments like stocks or bonds. This is especially true for funds that track a single commodity (like oil or wheat), versus diversified funds that include a broader basket.

Volatility can be unsettling, but it’s not necessarily a negative. It’s the natural result of supply-and-demand dynamics, geopolitical shifts, and weather events. If you understand your investment and have a long-term perspective, short-term price swings should not shake your conviction.

Some investors even use volatility to their advantage—buying during dips, or using cost-averaging strategies to build positions over time.

Asset Concentration

Understanding the fundamentals of your investment helps guard against emotional responses to unexpected price movements. When you understand the true value of your investment, price swings may be viewed as exciting opportunities to either buy more (of an undervalued entity) or sell what you have (at a price well above its true value).

That said, drastic price swings can be very emotionally taxing and may not be suited for every investment situation. Understand the structure of your investment. Typically, increased diversification results in decreased volatility. In a very concentrated portfolio, for example, the price movements of a single commodity will significantly impact the value of the total portfolio.

Diversification can reduce exposure to volatility. Consider spreading your investment across:

• Different commodity categories (agriculture, energy, metals)

• Different asset classes (physical commodities, stocks, ETFs)

• Different time horizons (short-term trends vs. long-term trends)

Diversification won’t eliminate risk, but it can smooth out the impact of unexpected events.

Psychological Risk: Your Emotions Can Hurt Your Returns

Even if you pick a solid commodity investment, your own psychology can become a liability. Fear might push you to sell during a short-term dip. Greed (or the fear of missing out) might tempt you to chase a rally without understanding the fundamentals. And overconfidence might lead you to ignore warning signs or overleverage your position.

Being aware of your emotional tendencies is a key part of managing risk. Stick to your plan, follow your analysis, and avoid making decisions based on short-term noise.

Macroeconomic Factors: The Big Picture Moves the Market

Commodities are deeply tied to global economic trends. Prices can be influenced by:

• Trade policies and tariffs

• Geopolitical events (e.g., war, sanctions, alliances)

• Currency fluctuations

• Global supply chains

• Central bank decisions and inflation data

For example, in 2022, Russia’s invasion of Ukraine caused wheat and energy prices to spike due to supply disruptions and export bans. Events like these can have a powerful—sometimes unpredictable—impact on commodity prices.

That said, market reactions to such events can often be exaggerated and relatively short-term. Investigate and research macroeconomic events and understand how the fundamentals of your investment are truly affected. These price swings may present great buying opportunities.

While it is important to be aware of the broader macroeconomic landscape, it’s impossible to fully anticipate every global shock. But stay hungry for knowledge. Embrace the fascinating process of understanding macroeconomic dynamics and how they affect commodities prices.

Foreign and Emerging Market Exposure

Many key commodity producers are based in emerging or politically unstable regions. This adds an extra layer of risk to your investment.

Examples of such risks include:

• Political upheaval in oil-producing nations

• Currency collapses that affect export prices

• Corruption or inconsistent regulation in mining regions

You don’t need to avoid these entirely—but you do need to factor them into your research and expectations.

Other Risks: Know Your Investment

Many commodity ETFs and mutual funds use futures contracts to track performance. These don’t always match the spot price (the current market price for immediate delivery). This mismatch is called tracking error, and it can frustrate investors who expect their fund to move in sync with the underlying commodity.

Also be aware of:

• Contango/backwardation (When futures prices diverge from spot prices)

• Fund fees and structure (How is the fund built? Who manages it?)

• Liquidity (How easily can you exit your position?)

Before investing in a fund, review its historical performance, fund structure, and management quality.

Take Action

Apply this knowledge to your selected commodity.

Research Specific Risks:

1) What risks are unique to your commodity? Look into:

• Weather patterns and climate shocks

• Labour strikes or transportation issues

• Government regulation or export restrictions

• Currency or emerging market exposure
  

Study Real Events:

2) Identify moments in history when the price of your commodity dropped sharply. Ask:

• What caused the downturn?

• Could it have been anticipated?

• How long did it last, and what were the consequences?
  

Understand the Trade-off:

3) Every investment involves trade-offs. Ask yourself:

• What potential gain am I hoping for—and what risk am I taking to get it?
  

Assess Your Own Behaviour:

4) Be completely honest with yourself. Be humble and ask:

• How would you likely react if your investment dropped 20% overnight?

• Would you panic, or would you trust your research and stay the course?
  

Risk is part of the game. But when you understand it, respect it, and prepare for it, it becomes something you can work with, not something you run from. Your goal is not to eliminate all risk, but to know what you’re getting into and to stay in control when markets get noisy.