The first thing to understand about investing in commodities is that it's generally a lot more volatile than investing in stocks. The most conservative way to invest - other than just sticking your money in the bank - is low-yield, low-risk bonds like Treasury bills. Stock indexes and higher-yield bonds are riskier still, while individual stocks can offer great returns but also enormous risks.
Commodities are objects that come out of the earth such as orange juice, wheat, cattle, gold and oil. People buy and sell commodities based on speculation. For instance, if you thought hurricanes over Punjab were going to destroy much of the wheat crop, you would call your commodity broker and have them purchase as much wheat as possible. If you are correct, the price of wheat would be go up drastically because the crop has been destroyed by weather, making the surviving harvest worth a lot more. Almost all commodity speculators trade on margin, which results in substantial risk to the invested principal. The odds are heavily against anyone hoping to build permanent wealth in the commodity markets
With commodities, you're subject to three main factors:
- First, there's demand for the commodity you're investing in. If more people want oil, the price goes up (everything else remaining equal).
- Second, there's supply - this is where big shocks can come into play. Drought in agricultural regions or political unrest in oil-producing areas can spike the prices of those commodities.
- Third, there's the vehicle you're using to invest. There are many ways to trade commodities, but here are the most important ones: Exchange-traded funds (ETFs) track the commodities' price and trade on regular stock exchanges. Some mutual funds are weighted towards commodity investments.
Shares in companies that produce and sell goods like oil and silver usually track the price of those goods. Finally, futures contracts allow sophisticated investors to make bets on price movements. Futures contracts are a bit too risky and esoteric, although some people have made a fortune on them. For many, the simplest and easiest way to invest in commodities is with ETFs. The SPDR Gold Trust ETF (GLD) tracks the price of gold, while the United States Oil Fund (USO) follows the price of light, sweet crude oil. The Power Shares DB Agriculture Fund is tied to 11 different agricultural products.
These funds buy and sell oil futures contracts so that the value of the fund moves up and down the same percentage as the actual price of the underlying commodity. Then, the managers issue shares that can be traded like any other stocks on major exchanges. The advantage of an ETF is the ability to buy and sell your shares at any time, making them very liquid. A riskier play is to buy shares in a company in your chosen commodity's industry. If you think the price of oil will increase 10 percent, you could invest in Oil Co. which might get a 15 or 20 percent boost from that oil price. But imagine if you'd invested in BP - you could have been wiped out, even as oil stayed more or less steady. Finally, some mutual funds, like Pico’s Commodity Real Return Strategy Fund, are heavily weighted towards commodities. If these are well managed, they can give better returns than stocks or ETFs.