Commodities Trading - Create a Well-diversified Portfolio

What are commodities and commodity trading? Commodities are composed of weighted averages of prices of oil, coffee, gold, wheat, etc, and commodity trading is the buying and selling of these products. And despite trending down for roughly thirty years, many investors still choose to trade in commodities, and most do well. How is it that this can occur?

The main reason is that the downward trending doesn’t tell the whole story. Traders use day-to-day price movements to make profits and so aren’t necessarily concerned with the overall trend. Absolute prices are not what matters in these trades, but the difference in buying and selling prices.

A further reason comes from trading strategies that utilize hedging. As commodities and stock prices often move in opposite directions, commodities often form a basis for hedging strategies.

Another reason stems from the contrarian stance of many investors. It is argued, with historical data support, that you can't make money by following the crowd. You have to do what others aren’t in order to profit. That's true within an investment type, and also across different investments.

It stands to reason that any well-diversified portfolio will have some of just about everything: stocks, bonds, cash and - in some cases - commodities. To diversify risk and income, an overall hedging strategy will have a bit of everything. For example, normally as bonds move down, commodities move up. Inflation tends to work on them in opposite directions.

Finally, it's an observable fact that many commodities have been moving up over the years. The most notable example is probably oil, with precious metals being the typical alleged loser. 'Loser' is a misnomer, though. Almost 30 years ago gold peaked, but after dropping drastically it has remained steady during most of that period, and has trended increasingly up the past few years, rising over 40% since 2003.

The rising price trend for gold, some would argue, will continue for some time to come. It’s certainly possible, given the latest views of the Federal Reserve on inflation. However, as with any investment, no one can be sure. It wouldn’t be called speculation if they could.

The following, however, is almost guaranteed. The world will continue to consume wheat, oil, gold, coffee and other common commodities. Another fact is that some of the commodities can't be replenished and the more you extract the harder it is to get what remains.

In the case of gold, that's certainly true, though with national governments holding the largest stores and moving to liquidate them, it will be under continued price pressure for some time to come. For example, Canada eliminated all its horded gold over the period 1980-2003.

It is also likely to become harder to recover oil. Recovery of North Sea oil peaked several years ago and has been declining ever since. The rate of supply isn’t likely to increase unless drastically new technology is developed, or environmental policies change. However, particularly in China, demand is continuing to rise.

Therefore, including commodities in your portfolio, at least in the form of ETFs (Exchange Traded Funds), is a good strategy. Also available are other mutual funds that focus on commodities, and these usually provide an additional advantage as they tend to move in the same direction as stocks, not opposite as with traditional commodities.

         

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