Do Commodities Have a Place in Your Portfolio?
There are several options to choose from when building an investment portfolio, such as stocks, bonds, and mutual funds. Commodities are another type of investment that can help investors hedge against inflation.
Affected by factors like demand and geopolitics, commodities are a high risk addition to investment portfolios. Investing in these goods, however, can yield excess returns for an investor’s portfolio if they can time the market right.
What Are Commodities?
Commodities are hard or soft goods, such as natural resources or agricultural produce, that can be used for other goods and services. These goods generally have consistent quality and utility regardless of the brand or business they’re produced by.
Investors tend to trade groups of basic goods in high demand. Some of the most consistently traded commodities include oil, gold, corn, and real estate, but many factors contribute to trading fluctuations and trends.
Rising Inflation
Many of these goods experience a rise in futures prices during periods of inflation. In most futures market scenarios, futures and spot prices converge as contracts approach expiration, with the difference indicating rolling yield or return on the investment.
When the futures price is higher than the spot price, the market is in contango. Investors that can buy low are essentially betting on inflation to increase the futures prices when the contract expires, allowing them to sell for a maximal positive return.
Commodity Volatility
Dependent on supply and demand, commodities tend to be unpredictable and volatile. Geopolitics, climate disruptions, and other factors can also play a role in fluctuations. For instance, gas prices stayed consistently low until 2022, when the Ukraine-Russia conflict created additional demand on the market.
Commodities have an average return of 22% during high inflation years compared to -1.9% during low inflation, meaning they can be a decent hedge against inflation when stocks and bonds may otherwise suffer. Despite high risk, commodities can offer portfolio diversification and excess positive returns.
Gaining Exposure
Investors can gain exposure to commodities through a few investment vehicles, trading in commodity-based futures, stocks, exchange-traded funds (ETFs), or mutual funds. Trading goods directly or investing in futures contracts can be risky and complicated and may not be appropriate for all investors.
ETFs are purchased like stocks and are an accessible and cost-effective commodity investment option for the average investor. They’re usually either focused on a single commodity, investments in future contracts, or they track the performance of a commodity index over time.
Diversifying With Commodities
Commodities typically have a negative correlation to assets like stocks and bonds, with commodities bearing higher returns when the latter suffers. Putting everything into commodities can be overly risky, but a strategic approach can be a great way to diversify portfolios and gain positive returns.
Many investors look to use their portfolio assets to generate retirement income later on. As investors near retirement, reducing allocation to commodities to maintain basic income streams can help minimize risk while still maintaining commodity exposure.