Diversifying Your Investments: Have you thought of investing in commodities?

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October 13, 2020 1:25 AM

If your portfolio is focused only on shares and bonds, investing in commodities offers you a way to hedge against portfolio risks

Having too many commodity investments in your portfolio is also not advantageous.

Diversification is the key to intelligent investing. While a vast majority of investors invest in equity and debt funds, they tend to ignore commodities as an asset class. While investing in commodities may not completely eliminate risk, it generally offers investors a safer edge during the time of inflation and economic uncertainties. Let us discuss the nuances of investing in commodities.

Mechanics of commodities market
Investments in commodities refer to trading in assets such as foodgrains, oil, gold, silver, wheat, rice, coffee, tea, metals, etc. Commodities can be classified into soft commodities which are usually crops that are grown and hard commodities that are extracted from mining. There are various ways to invest in commodities. For instance, one can invest in futures contracts, commodity-based mutual funds like natural resource funds, Basic/true commodity fund, Index funds, etc.

Advantages
One of the major advantages of investing in commodities is diversification. The commodity profits normally have low or very negative correlations with profits of other major asset classes. This is because when the prices of goods and services increase, the value of commodities needed to produce these goods and services will automatically rise. By keeping some commodities in the investment portfolio, investors can take advantage of the market upswing. Factors which affect shares and bonds do not affect commodities in the same magnitude. Further, commodities may respond differently to various financial and geopolitical situations.

Better hedge against event risks
Investing in commodities acts as a better hedge against event risks such as war, natural disasters and financial crises. For instance, owing to supply disruptions during a war there is a higher probability of increase in price of commodities like oil and foodgrains. So, these types of commodities work as a potential hedge against event risks.
Compared to investment in assets like real estate, investments in the commodity markets have higher liquidity. It is very easy to buy and sell commodity futures and investors can liquidate their position whenever they want.

Diversification is the key to intelligent investing. While a vast majority of investors invest in equity and debt funds, they tend to ignore commodities as an asset class. While investing in commodities may not completely eliminate risk, it generally offers investors a safer edge during the time of inflation and economic uncertainties. Let us discuss the nuances of investing in commodities.
Mechanics of commodities market
Investments in commodities refer to trading in assets such as foodgrains, oil, gold, silver, wheat, rice, coffee, tea, metals, etc. Commodities can be classified into soft commodities which are usually crops that are grown and hard commodities that are extracted from mining. There are various ways to invest in commodities.  For instance, one can invest in futures contracts, commodity-based mutual funds like natural resource funds, Basic/true commodity fund, Index funds, etc.
Advantages
One of the major advantages of investing in commodities is diversification. The commodity profits normally have low or very negative correlations with profits of other major asset classes. This is because when the prices of goods and services increase, the value of commodities needed to produce these goods and services will automatically rise. By keeping some commodities in the investment portfolio, investors can take advantage of the  market upswing. Factors which affect shares and bonds do not affect commodities in the same magnitude. Further, commodities may respond differently to various financial and geopolitical situations.
Better hedge against event risks
Investing in commodities acts as a better hedge against event risks such as war, natural disasters and financial crises. For instance, owing to supply disruptions during a war there is a higher probability of increase in price of commodities like oil and foodgrains. So, these types of commodities work as a potential hedge against event risks.
Compared to investment in assets like real estate, investments in the commodity markets have higher liquidity. It is very easy to buy and sell commodity futures and investors can liquidate their position whenever they want.
Lower margin, longer trading hours
An investor who likes to invest in commodity futures needs to deposit margin money with the broking house. It ranges between 5% to 10% of the whole value of the agreement. This is much lower than the margin necessary for other asset classes. So, with the lower margins, investors can take larger positions which will increase the potential for higher profits.
Another advantage of investing in commodities is the longer trading hours compared to stock market trading hours. For instance, the trade timings for the Multi-Commodity Exchange (MCX) is from 9.00am to 11.30pm during week days for non-agri commodities.
Drawbacks
Commodities are the most volatile asset among other asset classes. According to an empirical study, commodities are twice as volatile as shares and four times more volatile than bonds. This volatility makes commodities very risky for some conservative investors. On one hand, it provides a better opportunity to earn a profit. At the same time it is a high-risk, high-reward investment. Having too many commodity investments in your portfolio is also not advantageous.
To conclude, if you are looking to hedge against your portfolio which is focused only on shares and bonds, investing in commodities can be the right option for you to manage the risks.
commodities trading
It offers a safer edge during the times of inflation and economic uncertainties
You can invest in futures contracts, commodity-based mutual funds like natural resource funds, basic/true commodity fund, index funds
Commodities are the most volatile asset among other asset classes
This volatility makes commodities very risky for some conservative investors

An investor who likes to invest in commodity futures needs to deposit margin money with the broking house. It ranges between 5% to 10% of the whole value of the agreement. This is much lower than the margin necessary for other asset classes. So, with the lower margins, investors can take larger positions which will increase the potential for higher profits.

Another advantage of investing in commodities is the longer trading hours compared to stock market trading hours. For instance, the trade timings for the Multi-Commodity Exchange (MCX) is from 9.00am to 11.30pm during week days for non-agri commodities.

Drawbacks
Commodities are the most volatile asset among other asset classes. According to an empirical study, commodities are twice as volatile as shares and four times more volatile than bonds. This volatility makes commodities very risky for some conservative investors. On one hand, it provides a better opportunity to earn a profit. At the same time it is a high-risk, high-reward investment. Having too many commodity investments in your portfolio is also not advantageous.

To conclude, if you are looking to hedge against your portfolio which is focused only on shares and bonds, investing in commodities can be the right option for you to manage the risks.

 

commodities trading
It offers a safer edge during the times of inflation and economic uncertainties. You can invest in futures contracts, commodity-based mutual funds like natural resource funds, basic/true commodity fund, index funds
Commodities are the most volatile asset among other asset classes
This volatility makes commodities very risky for some conservative investors

 

The writer is a professor of finance and accounting, IIM Tiruchirappalli

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