8 Things Everyone Should Know About the Commodities Markets

By Tim Lemke on 14 April 2016 1 comment

It's common in the investment world to hear a lot about commodities. These are things like oil, soybeans, gold, and even cattle, which can be bought and sold on exchanges, similar to stocks.

The price of commodities plays a big role in our economy, from how much it costs to fuel our cars, to the price of a gallon of milk. It's possible to earn money trying to predict how the price of these commodities will move, although it can be risky.

Investing in commodities is not for beginners, but it's helpful to know some of the basics of how they work and how they may impact other parts of your portfolio — and even your day-to-day life.

1. There Are Four (or Three) Basic Groups of Commodities

Commodities can be lumped together in an infinite number of ways, but are generally placed in four groups:

  • Energy (Things like oil and natural gas)
  • Metals (Gold, silver, platinum, zinc, etc.)
  • Livestock and meat (Cattle, pork bellies, hogs, etc.)
  • Agricultural (Corn, soybeans, coffee, and so forth)

Some people like to group agricultural and livestock together. But no matter how they are categorized, it's possible to invest in certain groups of commodities through funds and ETFs that track specific commodity exchanges.

2. The Chicago Mercantile Exchange Is the Place

We all know the New York Stock Exchange and NASDAQ as the places to buy and sell traditional stocks. But for commodities, the world's largest exchange is the Chicago Merc or CME, located on Wacker Drive. About 80% of the trades on the CME are done electronically, but a portion still come from "open outcry" in which traders stand in a "pit" and call out orders, prices, and quantities.

3. They Are Volatile

If you're looking for slow and steady growth, commodities aren't for you. In fact, volatility is pretty much the norm, and it's gotten worse in recent years. A report from consulting firm Deloitte said that several commodity groups including oil, natural gas, coffee, and copper, have seen price increases of 30% to 60% over a three to six month period. And between 1997 and 2012, there were far more extreme price changes than the previous 15 years.

4. Commodities Are Impacted by the Dollar

Just about every aspect of the world economy is impacted by currency values in some way, but commodity prices are especially sensitive. That's because commodities are often priced in dollars around the world due to faith in the American economy. In the U.S., a strong dollar usually means low prices for commodities. And the inverse is true; it will take more dollars to buy commodities when the value of the dollar goes down, so commodity prices go up as well.

5. Weather and World Events Can Affect Commodity Prices

Commodity investors often find themselves becoming experts in meteorology and world affairs, because of the various things that can impact commodity prices. Maybe it's a drought in the Southeast United States that has taken out soybean crops. Or perhaps the threat of a hurricane that could temporarily shut down oil refineries. Everything from floods to flies to civil war can impact the supply of certain goods, thus impacting prices.

6. It's Okay for Your Portfolio to Have Commodities, But Not Too Many

Many financial advisers suggest holding commodities along with stocks, bonds, and real estate as part of a diverse portfolio, particularly if your nest egg is large. But keep in mind that commodities don't pay dividends or interest, and very few have a terrific track record of gains over the long term. Charles Rotblut of the American Association of Individual Investors told the Wall Street Journal that most investors should only consider investing in commodities after having the basic allocations down. In the same publication, Rick Ferri, an advocate of low-cost index fund and ETF investing, called commodities "dead money" and said most people would be better off without them.

7. You Can Invest in the Future With Commodities (Sort Of)

Investors who want to avoid some of the risk of commodity price fluctuations can buy something called a "futures contract," which is essentially an agreement to buy or sell a commodity at a certain price at a certain date. Investors who are sellers get to lock in prices this way. Investing with commodities futures is not for inexperienced investors, as it requires a certain amount of cash up front and often involves the borrowing of money, or leverage. It is easy to lose a lot of money in a short amount of time this way.

8. It's Possible to Have Commodities Exposure Without Owning Commodities

If you don't feel comfortable trading commodities futures or owning commodity ETFs, you can buy shares of stock in companies that work with those commodities. For instance, an investor can buy shares of a company involved in gold mining, or in producing equipment for oil fields. By going this route, it's possible to diversify your portfolio with exposure to commodities, but avoid some of the volatility.

Are there any commodities in your portfolio?

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Guest's picture
Stefan @Mllnnlbudget

The only commodities I keep in my portfolio are stocks rather than options because I understand that market significantly better. I own XOM (Exxon) and Chevron. Got both for a steal during February and couldn't be happier. Commodities is a very wide category and it would be very hard for investors to understand the entire sector unless they are involved in it.

Tim Lemke's picture

Stefan -

I'm like you. It's easier to understand stocks, so I personally prefer to own shares of companies involved in the industries. For most investors, it makes more sense to invest in a company like Exxon than to mess around with oil futures.