Commodities are frequently disregarded as part of an investing portfolio, with many financial consultants advising stock and bond allocations (or funds holding those two asset classes). However, other experts suggest that investors’ portfolios require more diversity to help decrease risk and level out returns.
Here are some things to think about before investing in commodities, including numerous options for doing so and a few pitfalls to avoid.
What to Look Out For When Investing in Commodities?
Investors may talk about commodities as if they’re all the same thing, but commodities are made up of hundreds of different goods, each with its own supply and demand dynamics.
The law of supply and demand applies
Supply and demand are at the heart of commodity businesses. The product is generally the same in every commodities sector. Cattle are cattle, and wheat is wheat. As a result, all producers are price takers and are unable to set prices in normal times. Numerous commodity sectors are great instances of “completely competitive” businesses, in which many customers seek an undifferentiated product and suppliers are unable to provide unique products.
Price fluctuations are caused by supply and demand mismatches, which can arise for a variety of reasons. If demand increases or supply becomes constricted, prices may rise. One of the more significant examples was timber prices, which rose in 2021 because supply had not completely recovered after being shut down as part of the larger COVID economic downturn.
However, if demand falls or supply returns, prices may return to previous levels or perhaps fall further. The same thing is happening with lumber when supply returns and the situation returns to normal.
Investing in commodities necessitates an awareness of the supply-demand scenario, where it is headed, and how quickly it will arrive. Prices fluctuate a lot, and they don’t always stay the same.
In commodities, the lowest cost wins
Because commodities sectors are price-takers, the businesses who produce at the lowest cost win. They make the highest profit per unit, and they’ll be able to survive as long as the market is open, even if the price of the product falls.
Companies that produce at high expenses are generally the most vulnerable. They won’t be able to produce at a profit if prices decrease, and they won’t be able to eke out any more since they’re price-takers. As a result, if the industry does not come around fast enough, they may go bankrupt.
Of course, if you’re trading the price of the product itself, you may have mixed feelings about any one producer, albeit if supply is disrupted, prices may rise.
Price surges are frequently transient
Commodity prices will tend to gravitate towards an equilibrium price that balances demand and supply over time. However, commodity prices are volatile in the near term, and they will likely to exceed this equilibrium price both to the upside and to the downside. As a result, markets frequently overcorrect as producers rush in to fill a supply gap, but then remain too long to recoup their investment, lowering the commodity price below a sustainable level.
As a result, price increases and even significant drops are frequently fleeting.