Investing in commodities has grown in popularity over the last few years, and investors can now, more than ever, take part in this ever-growing market segment. Most importantly, adding commodities to the mix could benefit an investment portfolio.
What exactly are commodities? Commodities are raw materials used to create products for consumer use. They include energy products (oil and natural gas), agricultural products (corn and wheat), precious metals (gold and silver), and livestock (cattle and hogs). In addition, soft commodities (also known as “softs”) comprise items such as cotton and sugar that cannot be stored for long periods of time.
How can someone begin investing in commodities? Buying the physical commodity is one approach, but, for practical purposes, it might not be feasible for an investor to buy and hold actual bushels of corn or barrels of oil. Investors have the option of owning stock in a firm that derives its revenue from the sale of physical commodities. Certain sectors such as oil and natural gas, mining, or agriculture are prime examples. Investors can also invest in various mutual funds or exchange-traded funds (ETFs) that focus on commodities.
Historically, adding commodities to a portfolio comprised of stocks and bonds has reduced portfolio volatility without sacrificing potential return. This image illustrates the risk and return profiles of two hypothetical investment portfolios over the past 20 years. The portfolio containing commodities generated a higher return while assuming less risk—meaning it experienced less volatility. Because traditional assets and commodities generally do not react identically to the same economic or market stimuli, combining these assets can often produce a more appealing risk/return tradeoff.
Commodities transactions carry a high degree of risk and a substantial potential for loss. In light of the risks, you should undertake commodities transactions only if you understand the nature of the contracts (and contractual relationships) into which you are entering and the extent of your exposure to risk. Trading in commodities is not suitable for many members of the public. Carefully consider whether this type of trading is appropriate for you in light of your experience, objectives, financial resources, and other relevant circumstances.
Government bonds are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest, while stocks and commodities are not guaranteed and have been more volatile than bonds. An investment cannot be made directly in an index. Diversification does not eliminate the risk of experiencing investment losses. Past performance is no guarantee of future results.