Understanding The Risks And Benefits Of Investing In Commodities

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Over the past decade, commodities have taken a back seat to equities and bonds as a popular investment option. But recent trends suggest they might be ready to make a comeback. If you’re reading this, you might be a part of a growing number of people asking, “Should I buy commodities now?”

The answer? Maybe. But before we explore the potential benefits of investing in commodities, let’s dive into some examples to discuss what makes these assets so unique.

A Commodities Overview

Commodities are generally produced through mining or farming activities. There are monetary commodities like gold; industrial metals like copper and zinc; agricultural commodities like corn, soy, and wheat; and energy commodities like oil, natural gas, and uranium. The techniques used to mine or grow commodities have steadily improved since the beginning of the industrial age, making production more cost-efficient over time.

Unlike companies and bonds, commodities don’t generate any cash flow by themselves. This means your return on investment (ROI) relies solely on the difference between your buy and sell prices. Commodities are generally cyclical, and their prices at times can be quite volatile.

All of this insight brings us back to our original question: Why invest in commodities?

A Useful Hedge

While stocks generally outperform commodities, there are exceptions. In an inflationary environment, commodity prices tend to go up — and the opposite is true of a deflationary environment. These price movements can sometimes yield substantial returns relative to other asset classes, making them a valuable component of a properly diversified financial portfolio.

During the stagflation period of the 1970s, for example, stocks generated a -2% annualized return while bonds generated a -4% annualized return. Gold, silver, and other commodities generated better returns consistently. Gold can be a particularly useful diversifier because its status as a monetary metal means it has no correlation to stocks. During each of the major market crashes of the past 50 years, owning gold significantly mitigated investors’ losses from plummeting share prices.

Today, it’s safe to say that commodity prices have been in a bear market since peaking in 2008. In stark contrast, U.S. stock markets have experienced substantial growth since the Great Recession.

When commodity prices are low — as they are now — producers can struggle to secure capital as investors look elsewhere. With less money, they cut back on expenditures necessary to mine or grow more commodities. Supply dwindles, causing prices to stabilize and then start rising once again.

When prices are high, the opposite can happen. Capital flows to producers, who can expand capital expenditures until oversupply halts growth and ultimately sends prices back downward.

Timing Is Everything

To capture the benefits of investing in commodities, it’s crucial to buy at the right time of a commodity cycle. We are currently far closer to the bottom of the cycle than the top, which suggests that commodities could have room for growth in the coming years. If you’re interested in adding this unique asset to your investment portfolio, here are two strategies to consider:

  • Buy some gold as a hedge. Several economic indicators suggest that significant inflation is approaching, which means it could be a great time to own gold. Its role as a reserve asset and store of value might provide investors with a refuge during any monetary crisis.
  • Invest in high-quality producers. Commodities producers that have plenty of liquidity in the form of cash reserves will be more equipped to withstand significant cyclical downturns. Even better, downturns might give them opportunities to acquire weaker competitors, increasing market share and perhaps also share prices.

Your investments should be based on your belief about the commodity cycle and the future monetary environment. Although there are several distinct advantages of investing in commodities, they should still represent one of many uncorrelated positions in your portfolio.

Before fully embracing commodities, spend some time familiarizing yourself with what you’re getting into — and the risk that comes with it. By getting to know whichever commodities are on your radar, you can then take steps to maximize that investment and build a stronger portfolio.

Note: This article originally appeared at ValueWalk.

About the Author

Adam Strauss is the co-CEO of Pekin Hardy Strauss Wealth Management. The firm takes a long-term view toward wealth preservation and growth, thinking deeply about business and debt cycles. It seeks opportunities to invest in undervalued, high-quality companies that are responsibly managed. Adam is also a portfolio manager of a publicly traded, value-oriented, global allocation mutual fund. He received his bachelor’s degree and an MBA from Stanford University; he currently resides in Chicago.