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Commodities are tangible commodities that can be traded and exchanged for other similar basic goods. Some common examples include crude oil, corn, and livestock. Raw materials are generally interchangeable, regardless of the producer.
Raw materials are often divided into two categories: hard and soft. Hard commodities refer to natural resources that must be extracted or mined, and include precious metals such as gold and silver or energy sources such as crude oil and natural gas. Soft commodities generally include livestock and crops.
Here you’ll find additional categories and examples, how and why to invest in commodities, the risks to consider, and what makes commodities different from stocks.
Goods categories and examples
| Difficult | Examples |
|---|---|
| Precious metals | Gold, silver, platinum |
| Industrial metals | Aluminum, nickel, zinc, copper, lead |
| Energy | Crude oil, fuel oil, natural gas, gasoline |
| Soft | Examples |
|---|---|
| Agriculture | Corn, soybeans, wheat, rice, cocoa, coffee, cotton, sugar |
| Cattle | Lean pigs, live cattle, feeder cattle |
How commodity prices are determined
This is evident from research by World Bank in 2020Since 1996, sudden shocks to the global economy have been the main cause of commodity price instability. About 50 percent of price fluctuations can be attributed to shifts in global demand, while about 20 percent can be attributed to changes in global supply.
At the most basic level, fluctuations in purchasing and sales cause changes in commodity prices. In other words: supply and demand is the name of the game. Commodities are also often vulnerable to environmental factors such as weather conditions and disasters – think droughts, forest fires and floods, to name a few.
Why invest in commodities?
Commodities have historically shown a positive correlation with high inflation, meaning returns tend to rise during periods of inflation. As inflation rises and the value of the dollar falls, hard assets such as oil, gold and silver tend to rise. By adding commodities to an investment portfolio, investors can help protect against inflation.
As an asset class, commodities may be uncorrelated or inversely correlated with other assets in the portfolio, such as stocks and bonds. This helps smooth investment returns over time and can lead to less annual volatility in an investor’s portfolio, all else being equal.
How to invest in commodities
Investing in commodities involves a lot of complexity, so it is not perfectly suited to all types of investors. However, there are many ways to invest, including buying commodity futures, ETFs, commodity-linked stocks, mutual funds and commodity-linked bonds. You can also invest directly in commodities. For example, buying gold or silver, which some investors do as a way to hedge against inflation.
“Investors need to understand that the only way to make money in commodities is for the price to rise, unlike stocks, which can rise due to the underlying company’s growing cash flow,” says James Royal, chief investing writer at Bankrate. “If you buy a gold bar, it will still be a gold bar in ten years, so you have to buy at a time when the commodity is undervalued. But determining when a commodity is undervalued can sometimes be quite difficult.”
For beginners, it is advisable to stick to ETFs and mutual funds as they offer protection through indices and professional management. It’s probably best to leave commodity producer stocks and futures contracts to experienced investors.
“More sophisticated investors are turning to futures because they can help magnify the price movements of commodities, turning small swings into bigger profits,” says Royal. “Of course, futures leverage works both ways, potentially leading to significant losses as well.”
Risks of trading commodities
The primary risk in commodity trading is volatility, which involves large, often unpredictable price swings. This makes commodities attractive to speculators, and their actions can also influence prices. Unlike stocks, commodity profitability tends to move in the opposite direction of the stock market trend.
“Commodities are among the most volatile investments,” says Royal. “When they are hot, commodities can skyrocket by hundreds of percent within a year, but overall price performance will not last long as the market adjusts and commodity producers ramp up operations to accommodate those higher prices. Commodities are therefore not ‘set it and forget it’ investments.”
Moreover, environmental damage continues in sectors such as livestock, agriculture, mining and extraction, despite global legislation promoting sustainable practices. Commodities carry significant risks, greater than those of equities, due to their rapid price fluctuations influenced by factors such as supply and demand, government policies and speculation.
It is important that investors understand that the drivers of commodity prices are varied, so you cannot talk about commodities as a one-size-fits-all. For example, the factors that influence gold prices have nothing to do with corn prices. So it is essential to understand individual markets, and not just ‘commodities’ as a whole.
—James Royal | BANKRAAT HEAD WRITER, INVESTING AND ASSET MANAGEMENT
Stocks versus commodities
Stocks represent ownership of the company issuing the stock, while commodities are goods. Commodities are often traded using futures – a form of speculation – but it is not the only way to invest in commodities. As discussed above, investors can buy shares of companies that produce commodities or ETFs of physical commodities or ETFs by producers of raw materials. Therefore, stocks and commodities are not mutually exclusive.
When it comes to commodity futures versus stocks, these two asset classes differ in how they are used by investors. In many cases, stocks are held for many years to benefit from long-term market trends, while futures are traded more frequently on the day, subject to swing tradies, or scalped because their price is influenced by fundamental factors that favor shorter durations. time frames in volatile markets. However, these are generalizations and you can hold stocks for a period of time, and you can hold futures contracts until they expire.
Finally, both stocks and commodities can be affected by interest rates, but the main driver for commodities is supply and demand, while stocks can be affected by business performance (earnings and profitability), market sentiment, valuation and more.
In short
Commodities can be a valuable asset to an investor’s portfolio, potentially offering greater returns than stocks over specific, often shorter, periods of time. They can also help diversify and hedge against inflation. However, understanding how to invest in commodities and the risks inherent in trading them is essential to successful investing.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making any investment decision. In addition, investors are advised that the past performance of investment products does not guarantee future price increases.
