Many investors regard trading in commodities as risky. The complexity and volatility of commodity markets deter people from investing here. But a well-planned commodity investment can be beneficial for your portfolio. It also offers a host of benefits. Here’s a look:
Commodities can diversify a portfolio. Commodity returns usually have low or negative correlations with the returns of other major asset classes. So often, when bonds and stocks fall, commodities rise. Sometimes, there may not be any connection between the returns at all. Factors that affect returns on stocks and bonds, for example, do not affect returns on commodities in the same manner. Besides, commodities may react differently from other assets in various economic and geopolitical situations. For example, the prices of stocks may fall during a financial crisis. But gold prices may rise as demand for this safe asset increases. A diversified portfolio with a low correlation between its assets tends to have less volatile returns. Thus, investing in commodities ensures diversification and improves risk-adjusted returns.
2. Inflation protection
Inflation has a different impact on commodities than financial assets like stocks and bonds. This is because inflation causes currency to depreciate. This erodes the real value of financial assets like stocks and bonds. Commodities, however, maintain their value and price even during high inflation. In this environment, investors can turn to hard assets such as gold and other precious metals.
3. Hedge against event risk
Events such as natural disasters, wars, and economic crises can lead to depreciation of an investor’s assets. This is an ‘event risk’. Such events affect financial assets like stocks and bonds negatively. They may also lead to a rise in the prices of certain commodities. For example, supply disruptions due to wars may raise the prices of commodities like oil. So, these commodities may act as a potential hedge against some event risks—a buffer against losses.
Unlike investment in assets like real estate, investment in commodity futures offers high liquidity. It is easy to buy and sell commodity futures. An investor can liquidate his position whenever required.
5. Trading on lower margin
An investor in commodity futures needs to deposit a certain amount as a margin with the broker. The margin can be close to 5–10% of the total value of the contract. This is much lower than the margin required for other asset classes. Thus, the investor can take larger positions while investing less capital. This also helps increase the potential for high profits.
6. High returns
Commodity markets are volatile. They can experience huge swings in prices. For example, war in a major oil-producing country like Iraq can cause oil prices to shoot up. Smart investors can take advantage of these price swings to make gains. Well-planned commodity investments can provide higher returns than investments in other assets.