Investors have access to a number of different types of assets that they can put their funds into to try to generate a profit. Investments don’t have to be limited to traditional stocks and bonds, sometimes the most valuable investments are the tangible goods that are all around us—these are called commodities.
What are commodities?
Commodities are an asset class made up of raw materials used to make consumer goods. These materials can help diversify an investor's mix of assets and spread risk across different asset types.
“A commodity is a good or service whose wide availability diminishes the importance of factors other than price (such as brand name, uniqueness, or appeal) in determining its value," says Thomas Samuelson, CFA, CMT and Chief Investment Officer at Vineyard Global Advisors. "A commodity is fungible, in that there is typically little differentiation between supply from different sources.”
Some of the most common commodities to invest in typically fall into one of the following categories:
- Agricultural: This type of commodity usually includes goods like coffee, corn, sugar, soybeans, and wheat. These crops are commonly used in popular consumer products and can be a source of food for humans and livestock as well.
- Energy: Energy commodities include crude oil used to fuel transportations and the production of plastics, natural gas used for electricity, and gasoline, which powers personal vehicles.
- Metals: Metals include gold, used in making jewelry; silver, also used for jewelry and many other industrial uses as well; and copper, the most widely used form of electrical wiring.
- Livestock: Popular livestock like cattle and hogs are considered commodities.
How do you invest in commodities?
There are a few different ways you might invest in commodities or gain exposure to them:
- Purchasing the physical commodity. It’s possible to purchase a raw commodity, like a gold bar. However, if you go this route, you’ll need to account for the costs associated with holding a physical commodity like storage fees.
- Investing in commodity stocks or ETFs. If investing in physical commodities isn’t your speed, you can indirectly invest in commodities by investing in commodity stocks. These are stocks in companies that produce or process certain commodities. "This approach benefits from both commodity price increases and the potential of the company to add value by increasing production of a particular commodity or providing income through the payment of a dividend,” says Samuelson. A commodity ETF tracks the prices of a commodity or that commodity's corresponding index and gives an investor ownership over a set of contracts backed by the commodity.
Pros and cons of investing in commodities
Like any other investment, commodities are not without their own set of benefits and drawbacks. If you’re thinking about investing in commodities, here are some of the major pros and cons to note:
View this interactive chart on Fortune.com
Pro: Commodities can generate short term profits. There’s no real way to time the market, but if you happen to purchase and sell a commodity at the right time, you could generate a significant profit. "Since futures contracts generally require only a 5% margin, you could control $100,000 of copper for an initial investment of only $5,000. If the underlying price of copper rose 10%, the value of the copper you control would increase from $100,000 to $110,000 providing a $10,000 profit, but the return on your initial investment of $5,000 would be 100% ($10,000 profit on $5,000 initial investment),” says Samuelson. “Of course, you need to be right on the direction of the price of copper, and you can get a margin call requiring you to put up more money if the position moves against you.”
Pro: Commodities can be a hedge against inflation. These assets tend to rise during times of high inflation when the value of the dollar sinks. According to 2021 research from Vanguard based on the Bloomberg Commodity Index, a 1% rise in unexpected inflation would produce a 7% to 9% rise in commodities.
Con: Commodities can be extremely volatile. While commodities may not behave like other asset classes, they can still be risky. "Commodities are notoriously volatile and predicting their price movements can be difficult,” says Samuelson. “Unknowable events such as weather, geopolitics and the global economic outlook can dramatically impact the supply and demand, and thus the price of commodities.”
Con: Commodities don’t produce income for investors. Some investments like stocks, bonds, and real estate produce regular income for investors through dividends or rental income, but commodities do not produce income for investors unless they’re sold and a profit is realized from that sale.
The takeaway
Knowing the different types of investments available for you to invest in and how they typically behave can help you broaden your scope, diversify your portfolio and potentially help hedge against inflation during times of economic turmoil.
