Commodities are a popular part of a diverse portfolio – their inherent value often serves to protect against declining stocks and shares valuations, and many investors appreciate that they are pegged to a physical substance in one form or another.
However, commodities often display greater volatility than other forms of investment, and if you find your funds in a particular commodities contract that is close to expiry, you can stand to make substantial losses with no time left to recover.
So if you want to invest in commodities as a way to protect against risks elsewhere in your portfolio, the question is how to hedge against the risks posed by commodities themselves?
A good way to start is by setting yourself a ‘credit limit’ – assigning a fixed sum or percentage of your total investment fund to commodities, while keeping the rest in other investment vehicles.
Commodities are not only appreciated for closely tracking the physical materials they represent; they are also seen by some investors as a way to track rising prices due to inflation.
Because of the direct link with real-world assets, inflation gains are often mirrored directly in the value of commodities contracts, allowing a carefully managed investment fund to track the rate of inflation higher.
At the same time, during a recession when inflation is low, commodities like gold often perform well as investors’ first port in a storm, seen by many as a ‘store of value’ compared with devaluing currencies during widespread economic turbulence.
A vicious circle
The problem as more people look to commodities as preferred investment vehicles is that their value becomes more driven by investment than by the real-world assets they are supposed to track.
Some critics argue that commodities are unlikely to significantly outperform inflation over time – for exactly the same reasons already outlined above – and that because of this, they should form only a relatively small part of portfolios.
Instead, they recommend a flexible approach, increasing the amount allocated to commodities at times of turbulence and cutting back when their value is more closely tracking inflation, and especially when storage costs associated with the physical assets threaten to make overall gains negative.
A demanding future
One possible factor that could change the amount allocated to commodities in the future is rising demand for those assets that depend on global populations.
Whether it’s a food-related commodity or a desire-based asset like gold and other precious metals, increased populations mean increased demand, which traditionally means increased prices.
For investors, that potentially means justification to allocate more funds to commodities; however, it would of course also mean higher buy-in prices, or holding assets for much longer in order to realise any direct benefit from population growth.
Finally, when deciding how much to invest in commodities, remember that some of your other investments, such as ETFs, stocks and shares, may already be exposed to some extent to commodity values.
In order to avoid over-exposure – and unnecessary levels of risk – this indirect exposure should be included in the calculation.
Those investments can also be used to reduce the risk of commodities – for example by investing in an ETF that is only partially commodities-linked – thus giving you a way to increase your potential gains without significantly raising your risk.
Overall, taking everything into account, it is typical to see 5-10% of a diverse portfolio allocated to commodities.
As always, take other factors into account – such as emerging trends, potential for greater returns via other investment vehicles, and impacts like inflation and exchange rates – and commodities can yield good value as a small but integral part of your portfolio.
Disclaimer: The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.