Commodities and its importance in investment portfolios
Commodity Trading: An Overview
Let’s begin with the basics in brief. What is trading? Trading is considered as the exchange of goods and services between two entities. It is considered as the basic principle which forms the core of all economic societies and financial activities. A market is where any form of trade takes shape and depending on the kind of products, the market is defined. For instance, an area where stock trading takes place is named as a stock exchange.
Now moving to commodities, a consumable good or a product is termed as a commodity that is used commercially. Some of the examples of commodities include gold, industrial metals, oil, natural gas, and grains. All commodities are often classified under either of the following two categories:
1. Soft Commodities: soft commodities are the ones that are grown and cannot be stored for an extended period. Examples - Agricultural Products like grains, tea, coffee and livestock.
2. Hard Commodities: hard commodities are the ones that are obtained through mining and extraction. Examples - crude oil, natural gas and metals
What is an Investment Profile / Portfolio?
A portfolio can be defined as a collection of financial investments like stocks, bonds, commodities, cash, and cash equivalents that are owned by an investor.
There can be many different types of portfolios and portfolio strategies that one can use. It includes varied investments ranging from low risk to high risk based on the risk-taking capacity of an investor. The low-risk ones being the safer ones with more focus on stability and security while the high-risk ones focus more on returns and wealth creation.
Additional Read: Role of Commodity Market In India
Why and how commodities add value to your investment portfolios?
Commodities usually have a low to negative correlation to traditional asset classes like bonds and stocks. This means that with a fall in value of bonds and stocks, it’s possible that there could be a rise in the value of commodities.
Commodities may offer superior returns but are one of the most volatile asset classes available. Though they carry a higher risk than other investments, by adding them to a portfolio of traditional assets, the overall portfolio risk decreases due to the negative correlation.
The top three reasons to invest in commodity markets for all types of investors are:
- To diversify your portfolio
The key factor that determines the success of your portfolio is diversification. Diversification with regards to your portfolio means investing in various assets that are not correlated to each other. Gold is considered as the safest haven for investment in turbulent times as it usually tends to counter the downfall in the stock market, because it has a negative correlation with one another.
- To provide a hedge against inflation
The rise in the price of goods and services over time is known as Inflation. For any investment to be fruitful the returns have to beat the rate of inflation. High inflation rates often erode the real returns generated by traditional portfolios whereas commodities help stabilize the portfolio return above the inflation.
- To improve potential returns
Several factors such as demand and supply, the impact of natural calamities, exchange rates, and the economic health of a nation can significantly fluctuate the prices of individual commodities.
Since the commodity market is still an untapped area, a thorough research and proper implementation of strategies in commodities can help investors improve the returns on their portfolios.
The commodities market is very vast and deep. Investors have many ways to access it. Here are some of the ways available to investors to invest in commodities.
There are three primary ways to invest in commodities:
1. Owning the commodity in the physical form
It means taking possession of the commodity in the physical form. An example would be buying a piece of gold in the physical form.
2. Buying futures contract
A futures contract is an agreement between two parties to trade a commodity for a decided price & quantity. It also saves the trader the hassle of owning the commodity in the physical form. The commodities in this case are traded over an exchange just like the stocks are traded on a stock exchange.
3. Mutual Fund or ETF
This method is considered the best for an individual investor. It eliminates the need for owning the physical commodity and the risk of futures contract. In this method, the commodities can be held just like any other investment in the investors account.
Additional Read: How to trade in commodity?
- Investments and especially commodity-trading are grekat ways to generate another source of income which basically means, making your money to work!
- Commodities is an excellent way to add to a portfolio of traditional assets. It helps in reducing the overall portfolio risk due to the negative correlation.
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