Investing in Commodities: What to Know

As you build your investment portfolio, you may use several types of asset classes, all for various reasons. One that you may consider as an alternative to other securities, such as equities or fixed-income options like bonds, are commodities with tangible value in the real world.

In this article, we’ll highlight what to know about investing in commodities, including a breakdown of what they are, the role they tend to have in investors’ portfolios, and their benefits and risks. We’ll also explain some common ways to add commodity investments to your portfolio.

Understanding Commodity Investing

Commodities are a type of asset class comprising items with tangible value in the real world. Specifically, these are often items that hold meaning in various industries, such as agriculture, jewelry, and energy. Here are some examples:

• Precious metals (e.g., gold, silver, and platinum)
• Crude oil
• Natural gas
• Agricultural products (e.g., coffee, sugar, wheat, and corn)

Unlike investing in other securities such as stocks, whose value fluctuates due to company performance and external factors such as inflation and market volatility, commodities hold real value in the industrial world and, thus, follow a unique trajectory. Because of this, investors often include them in their portfolios as a means of diversification to ensure they can net positive returns against more volatile, differently performing investments.

As we’ll detail further in the article, you can add commodities to your portfolio in several ways. One of the most common is buying shares of a mutual fund or exchange-traded fund (ETF) that tracks certain commodities. This allows you to add the asset class to your portfolio without the time, effort, and storage associated with owning the item.

Role of Commodities in a Portfolio

Commodities can serve a multi-faceted purpose in an investor’s portfolio, specifically in the diversification they offer and their function as a hedge against inflation. This is largely because of their difference from other asset classes, such as fixed-income securities and equities, in terms of performance and where they derive their value.

Perhaps one of the most common reasons people choose to add commodities to their portfolios is the diversification it brings. As noted, commodity investments tend to have distinct performance trajectories than equity or fixed-income investments and, as we’ll explain below, may also react differently to inflation. Therefore, as a means of diversification, some investors may decide to incorporate some commodities, either in real life, such as holding gold, or through mutual funds or ETFs.

Investors may also gravitate toward commodities due to their function as a hedge against inflation. In simplest terms, this means that during periods of inflation where other assets, like stocks, bonds, or cash and cash equivalents, could lose value, commodities could appreciate or retain their value because of their real-life uses and demand. For example, people will continue needing oil to drive their cars or crops to buy in stores and put food on the table. Likewise, precious metals like gold will continue to exist in jewelry and as a store of value.

Pros and Cons of Commodity Investments

Commodity investments have specific advantages, including their characteristic as a store of value and different trajectories from other investments and asset classes. However, they also have some disadvantages to keep in mind before investing in them. For instance, while they can have tangible value, they may not yield the same volume of returns as equities, and they can also be prone to losses from a unique set of real-world risks.

Here are the pros and cons to consider about commodity investments:

How to Invest in Commodities

As an investor, there is a diverse array of ways you can go about adding commodities to your portfolio. Below are three methods of commodity investments:

Raw Physical Items

The first and not necessarily easiest method is buying the physical items. The general concept behind this is that you’ll keep them safe while watching their value appreciate over time and sell them for a profit later.

One of the most typical items an average investor may buy, for instance, is precious metal, such as gold or silver. You could do this by either buying bars or jewelry with the metal and then, as noted, storing it for safekeeping.

Owning raw physical commodities can be difficult. Because of their value, you’ll need to find a safe and secure place to store the items. For this reason, besides smaller items like gold or silver, which may be easier to keep in your home or a deposit box, larger commodities like agriculture or oil may be better suited for the following two methods.

Mutual Funds or ETFs

Another typical and relatively simple way to add commodities to your portfolio is to invest in mutual funds or ETFs that track or directly invest in the items you’re interested in investing in. For example, some funds may follow market indexes for certain items. Others, however, own the product.

Unlike buying the raw items, this is a more hands-off method of dipping your toe in the commodity market via a brokerage or retirement account. You don’t have to deal with the potential difficulty of being an owner of valuable commodities and trying to sell them.

Futures Contracts

A final way to invest in commodities is via futures. In short, this is a contract that allows you to trade a commodity at a specific amount in the future. According to the Commodity Futures Trading Commission (CFTC), however, this is a difficult, complex, and risky method that is often for institutional investors or individuals with significant knowledge of the industry.

Frequently Asked Questions

Are commodities a good investment?

Commodities can be effective investments if your goal is to diversify your portfolio or potentially hedge against inflation; however, this will depend on many nuances and factors, such as your circumstances and market conditions. As noted, commodity items don’t often yield as high returns as equities and, thus, may be a supplementary piece of an investment plan.

How can a novice investor add commodities to their portfolio?

A beginning investor could add commodities to their portfolio through mutual funds or ETFs that track items with tangible value, such as oil, precious metals, or agricultural products. However, to know if it’s the right choice for you, we recommend consulting the expertise of a financial advisor.

What is the biggest downside of commodities?

One of the biggest drawbacks of commodities is that they can drastically lose their value because of a range of political, geographical, or economic events. While they have a reputation for having different sources of value from equities, commodities are still prone to a unique set of risks.