While stocks and bonds are a fundamental part of how we build diverse portfolios, we might use other asset classes to help manage risk and boost potential returns. Specifically, commodities can help investors during periods of high inflation.
That said, not all commodities are created equal, and there are multiple ways to incorporate commodities into your portfolio.
What are commodities?
Commodities are raw materials that can be bought and sold, like oil, gold, coffee, corn, and wheat. Metals and energy resources tend to be known as hard commodities. Agricultural products—sugar, soybeans, and so on—are called soft commodities.
While you can buy these items at many retail locations, true commodity exchanges—where producers exchange goods for cash on the spot—are known as spot markets. (Actual delivery may take place later.)
Spot markets aren’t the only place to buy or sell commodities, however. It’s also possible to agree to a sale in the future, and futures contracts are one of the most common ways to buy and sell commodities.
Commodity futures
With futures, you agree to buy or sell the commodity for certain price in the future. This can help both buyers and sellers address large fluctuations in price.
Consider a corn farmer—he’s not sure what his crop will be worth at harvest. He might agree to sell 5,000 bushels of corn (the size of a standard futures contract) to a food producer for $25,000 dollars 3 months from now.
If the value of corn increases in those three months, the farmer makes less than what he would have made if he waited to sell the corn on the open market. Meanwhile, the food producer gets a deal. Let’s call this scenario A.
If, however, the value of corn falls in those three months, the farmer still makes $25,000 and the food producer overpays compared to the open market. We’ll call this scenario B.
Often, traders and investors buy futures contracts with no intention of purchasing the actual commodity. For instance, in scenario A, the futures contract is valuable—the food producer could buy the corn for $25,000, then turn around and sell it on the spot for more money. Speculators might buy or sell these contracts as a way to take advantage of the difference between the expected price of a commodity and its actual price.
Since futures contracts derive their value from an underlying asset, in this case corn, they’re known as a derivative investment and tend to carry more risk. Because of this, futures markets may not be as accessible, and therefore less well known, to retail investors.
In fact, the nature of futures contracts may be why commodities are less popular than other asset classes when it comes to portfolio management. But there are other ways to access these markets.
Beyond futures: Investing in commodities
When we talk about the price of a commodity, we are often referring to indices that track how much that asset costs in different markets all over the globe. For instance, some indices track the price of West Texas Crude oil. Others might track Brent Crude. These oils trade on both the New York Mercantile Exchange and the Chicago Mercantile Exchange, to name two. Indices track prices across both.
Investors who want to bet on commodity prices can use exchange-traded funds (ETFs) and mutual funds to do so. Some funds simply track these indices. Others make more deliberate investments.
Similarly, companies that deal with commodities can offer indirect exposure. When the price of oil falls, for instance, share prices at major oil producers tend to fall as well.
Should I invest in commodities?
Whether or not you should invest in commodities depends on your personal goals and circumstances as well as market conditions. But we’ll recap a few of the benefits and drawbacks.
Commodities derive their price from global supply and demand. Unpredictable events—a hurricane destroys Florida’s orange crop or war in Ukraine cuts off access to oil—can impact supply and therefore prices. This can lead to big, unexpected price swings (volatility).
On the other hand, commodity prices tend to move independent of stock and bond market prices. This makes commodities an excellent tool for diversifying a portfolio. To stick with an earlier example, war in Ukraine might rattle investors and cause the global stock market to fall while oil prices might increase due to a supply shortage.
Commodities may also protect investors from inflation. Gold, for example, tends to gain value when inflation is high.
Despite these benefits, commodities do carry risk and come with limitations. To start, commodities are finite; there’s a limited supply. Stocks, on the other hand, have the potential to increase without limit (at least in theory).
Consider gold: An ounce of gold in 1987 cost roughly $450. In 2021, that same ounce of gold was worth about $1,800—a 300% increase.
On the other hand, if you had bought a share of Tiffany & Co stock for $23 when it went public in 1987, and sold for $131.50 when the company was acquired in 2021, your money would have appreciated more than 470%.
Ultimately, commodities like gold can be a useful part of a well-diversified portfolio, and there are multiple ways to benefit from changing commodity prices. For instance, commodity prices are one of the many indicators used by Helios, our research partner, in their data-driven investment analysis.
If you have questions about commodities and your portfolio, we’d love to help.
