What are commodities & how do they work?

Investing requires a healthy balance of risk and growth with your timeline and financial goals. Commodities can be a useful investing tool in that equation, helping you diversify your portfolio and protect you against inflation.

For example, when the S&P 500 fell 18% in 2022, a broad basket of commodities gained 19%. However, just like any investment, commodities come with certain considerations. Let's explore how commodities fit into an investment portfolio and if they may be a good match for yours.

Commodities are raw materials or primary agricultural products that you can buy and sell. Examples of commodities include barrels of oil, bushels of wheat or ounces of gold. They're fundamental building blocks of the global economy.

You can broadly place commodities into three categories:

• Agricultural commodities: These include products like grains (wheat, corn and soybeans), soft commodities (cotton, sugar and coffee) or livestock (cattle and hogs).

• Energy commodities: This includes fossil fuels and energy-related products, such as crude oil, natural gas, coal and electricity.

• Metals: These include precious metals like gold, silver and platinum, along with industrial metals like copper, aluminum and nickel.

Commodities trading involves buying and selling contracts for the future delivery of physical commodities. It's conducted on organized commodity exchanges worldwide, and investors participate in these markets for various reasons, including portfolio diversification, hedging against price fluctuations and seeking a chance to turn a profit.

You can trade commodities in three places:

• Commodity exchanges: Commodities are traded on specialized exchanges like the Chicago Mercantile Exchange (CME), Intercontinental Exchange (ICE) and the London Metal Exchange (LME). These exchanges provide a platform for buyers and sellers to trade standardized contracts.

• Online trading platforms: Many online brokerage platforms offer access to commodities trading, allowing individual investors to trade futures, options, commodity stocks, mutual funds and exchange-traded funds (ETFs).

• Physical markets: In some cases, investors can participate in physical commodity markets by directly buying and selling physical goods through contracts and agreements with suppliers and consumers.

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Which asset allocation strategy fits your goals?

It can be risky to go all-in on a single asset or even limit yourself to a narrow slice of the investment universe. If those holdings lose value, your portfolio could go along for the ride. Read more on how to match your goals to a diverse asset allocation strategy.

Dive deeper

Trading commodities can be done through various methods and investment types. Some of the most common include:

• Futures contracts: Futures contracts obligate the buyer to purchase and the seller to deliver a certain quantity of a commodity at a predetermined price on a future date. You can trade these contracts on organized commodity exchanges, offering the potential for hedging and speculation. Not all futures contracts result in the physical delivery of the commodity. Many contracts are settled in cash, where you exchange the difference between the contract price and the market price.

• Options contracts: Options contracts give the buyer the right (but not the obligation) to buy (call option) or sell (put option) a commodity at a specific price within a specified timeframe. Options provide flexibility and can be used for hedging or speculation.

• Commodity stocks: Some investors choose to trade the stocks of companies involved in the production, processing or distribution of commodities. For example, investing in oil company stocks allows you to indirectly participate in the oil market.

• Commodity mutual funds: Mutual funds focused on commodities invest in a portfolio of commodities futures contracts and related investments. Professionals manage these funds and some diversify across various commodities.

• ETFs: Commodity ETFs are investment funds that track the performance of specific commodities or commodity indexes. ETFs are baskets of securities like mutual funds, but unlike mutual funds, ETFs trade intraday (within one day) on an exchange like stocks.

• Direct physical ownership: Investors can buy physical commodities such as gold bullion or silver coins, but could require storage and security considerations.

Trading commodities differs from trading stocks in several ways, including the underlying assets, market dynamics, risk factors and trading mechanisms. Here are some key differences:

As you decide whether to include these investments in your portfolio, consider the various benefits and drawbacks based on your risk tolerance and investment strategy:

• Diversification: Commodities often have a low correlation with traditional asset classes like stocks and bonds. When stock or bond prices aren't performing well, commodities may provide a buffer, potentially reducing overall portfolio risk.

• Inflation hedge: Commodities have historically served as hedges against inflation. During periods of rising inflation, the prices of many commodities tend to increase, helping protect the purchasing power of your investments.

• Tangible assets: Investing in physical commodities like gold or agricultural products can provide a sense of security. You're putting your money in tangible assets with intrinsic value.

• Speculative opportunities: Commodities markets can be highly volatile, creating opportunities for speculative traders to profit from price fluctuations. Active traders and investors who understand market dynamics may reap short-term gains.

• Price volatility: Commodity prices can experience rapid, unpredictable swings based on their risk factors. Historically, strong commodity price appreciation has occurred during short periods of time, while over long holding periods commodity returns have been flat or lagged behind stock and bond returns.

• Lack of income: Most commodities don't provide income in the form of dividends or interest. Unlike stocks or bonds, investors generally rely on price appreciation for returns, which can limit how much you can make.

• Storage and costs: Investing in physical commodities or commodity ETFs that hold physical assets may involve storage costs, insurance expenses and other expenses that could erode returns.

• Contango and backwardation: Futures markets for commodities often exhibit contango—when future prices are higher than spot prices—or backwardation—when future prices are lower than spot prices. These market conditions can affect the returns of your commodity futures investments.

Commodities can be a valuable addition to an investment portfolio, providing diversification benefits and potentially serving as a hedge against inflation and economic uncertainty. However, like any investment, they come with their own risks and considerations. They may not always be suitable for long-term holding periods or as significant part of a long-term asset allocation.

With this complexity in mind, you can seek professional investment guidance from a financial advisor. They'll help you assess your risk tolerance and strategize the best way to allocate commodities in your overall investment plan.