How To Lose Money Investing In Commodities2011-12-19
With real estate markets in the gutter, treasury yields at all-time lows, and equity markets plagued with instability, it’s no wonder that commodity investing has been surging in recent years. Many investors have hopped on board with the various benefits that these investments offer, including inflation protection, equity hedges, and diversification benefits to overall portfolios. Commodity are very powerful, yet often misunderstood tools. While the statistics vary, “as many as 90-95% of investors trading commodities lose money” says Matthew Bradbard of MB Wealth. That staggering figure has prompted significant backlash against commodities as of late, as investors have grown tired of these tumultuous investments [see also Dividend Special: Top Companies In Every Major Commodity Sector].
In an effort to make our readers part of the minority that profits from commodities, we outline some of the biggest mistakes that commodity investors make and what you can do to avoid crippling losses.
1. A Weak Stomach
One of the biggest issues commodity investors have is poor risk management with their investments. The hefty volatility that commodities display can often cause investors to exit a position prematurely, or to hold on for too long. Some may see signs of volatility and simply sell out to avoid further losses when holding on a bit longer would have led to profits. On the flip side, some investors see the volatility as a juicy opportunity and may keep faith in a position that has lost its way. Perhaps the most important thing an investors can do before making any kind of commodity trade is diligent research. Know how a commodity behaves and what factors play into its pricing. If the underlying fundamentals and technicals change, don’t be afraid to exit the position, but also make sure to not get discouraged by a few rough trading days [see also Three Things Wall Street Journal Didn’t Tell You About Commodities].
Commodity trading is meant to be volatile and for those who are unable to stomach the risk, it can be a brutal investing process. As a more general piece of advice, have a profit objective for each position and be willing to accept your losses when you were wrong. A sound and stable mind combined with good risk management will lead to smarter and more effective commodity trades.
2. Lack of Global Understanding
Though this could easily fall under the umbrella of “do your homework”, commodities in particular require special attention as an investment. As global investments there is a lot more at play than just the behavior of equity markets around the world. For example, cocoa, a popular soft commodity, is primarily produced in the Ivory Coast. The Ivory Coast has been home to heavy instability that has included multiple civil wars over the years. An investor with this knowledge could have made smarter trades on cocoa and kept themselves more informed on their position. In fact, the majority of the world’s most popular commodities are produced in emerging or frontier economies, making a global understanding key to trading [see also Invest Like Jim Rogers With These Three Agriculture Stocks].
To keep yourself informed on where commodities are both consumed and produced, check out our individual commodity pages which feature “Ultimate Guides” to nearly every major commodity. While it may seem a bit overwhelming, always keep in mind that everything from bad weather in China, to rough seas for shipping routes can have major impacts on your favorite commodity investments, so it is important to plan accordingly [see also 25 Ways To Invest In Silver].
3. Ignoring Fees
Keeping a watchful eye on the cost of investing certainly applies to the general investing field, but it is especially true for commodities. Investors have a number of options when it comes to exposure vehicles, including ETPs, futures, and stocks, but the fees associated with each are very different. Equity investments will almost always be cost-free but are indirect plays on commodities, leaving ETFs and futures as the primary trading structures. Trading futures contracts will incur brokerage fees, which may be fine if you only occasionally use futures contracts. But for those who are actively involved in the commodities markets, the constant rolling of futures positions can rapidly add up and eat into returns [see also Three Reasons Why Gold Is Overvalued].
This can make ETPs particularly attractive as they typically charge less than 1% for a constant futures position. But if this sounds too good to be true, its because in some cases, it is. Some of the most popular ETPs have expenses behind the scenes like brokerage fees that can erase value without the investors seeing a direct impact. That being said, there are plenty of exchange traded products that are very cost efficient, but each fund deserves a reading of the prospectus before investing. While ETPs come with their own set of risks, careful research can lead to funds that make futures investing much cheaper than employing the strategy on one’s own.
The bottom line here, no matter which investment methodology you prefer, is that while fees may seem miniscule, they can significantly add up over time. With commodity investing being primarily based on actively moving positions and the ability to change holdings on a moment’s notice, expenses are especially important to watch [see also MLPs: CEFs, ETPs, or Mutual Funds?].
4. Failure To Monitor
This one seems fairly obvious, but given the recent influx in commodity ETPs, the market has become readily accessible to those who may not be used to keeping a watchful eye on their positions. A commodity position will typically be measured in hours and days rather than months and years. Prices can be extremely volatile with seemingly insignificant events have a major trickle-down effect on the underlying investment, so the need for active monitoring is vital to the commodity space. Note that this piece of advice is most applicable to futures-based investments; there are a select few physically-backed commodity ETPs as well as equity investments that can be used for longer term strategies [see also Analyzing Five High Yielding Oil & Gas Pipeline Stocks].
If you do not have the time to watch your position through out the day, you probably have no business making the investment in the first place. Other than VIX contracts, commodities can be some of the most volatile investments available today and investors need to proceed with caution [see more at our Commodity Trading Center].
All in all, one of the most pressing issues with commodity investing is simply a lack of understanding. The options for this asset class are numerous, but many do not fully understand what it is they are buying and are left scratching their heads when they get burned. Commodity investing takes work, but the benefits it offers far outweigh the risks. In fact, any portfolio missing commodity exposure is considered to be un-diversified, as these investments provide vital advantages to any basket of holdings. But to put yourself in the minority of those who actually profit from commodity investing, be sure to do your homework and that you fully understand the risk/return profile associated with each investment [see also Dividend Special: Four Commodity Stocks Yielding Over 5%].
[For more commodity updates sign up for our free CommodityHQ newsletter]
Disclosure: No positions at time of writing.