Introduction
When most people think about investing, their minds immediately go to the stock market. They think about buying shares of their favorite companies. They might also think about the relative safety of bonds. These two asset classes, stocks and bonds, are the traditional cornerstones of most investment portfolios. However, there is another major asset class that forms the literal building blocks of our global economy. This asset class is commodities.
Commodities are the raw materials that we grow, extract, and use to create everything in our modern world. They are the fuel for our cars, the food on our tables, and the metals in our buildings and electronics. While you may not trade them directly, their prices have a profound impact on our daily lives. This guide will clearly define what a commodity is. We will also explore the different categories of commodities. In addition, we will discuss the reasons why investors choose to include them in their portfolios and the common ways to do so.
Defining Commodities: The Building Blocks of the Economy
First, let’s establish a clear definition. A commodity is a basic good or a raw material that is used in commerce. The single most important characteristic of a commodity is that it is fungible. This means that a unit of the good is essentially the same, regardless of who produced it or where it came from.
For example, one barrel of Brent crude oil is interchangeable with any other barrel of Brent crude oil. One bushel of corn from one farm is, for trading purposes, the same as a bushel of corn from another farm. This standardization and interchangeability are what allow commodities to be bought and sold in massive quantities on major global exchanges.
Think of it with this simple analogy.
- The stock market is like a collection of unique, branded products. A share of Apple is not the same as a share of Ford. Each company is distinct.
- The commodities market, in contrast, is like the bulk goods aisle at a giant warehouse store. A bag of raw sugar is just sugar. Its value is based on the underlying substance itself, not on the brand name that is printed on the bag.
The Major Categories of Commodities
The world of commodities is vast. It is typically broken down into two main groups, which are then further divided into sub-categories.
Hard Commodities
These are natural resources that must be mined or extracted from the earth.
- Energy: This is the largest and most closely watched segment of the commodities market. It includes crucial global resources like crude oil (with major benchmarks like West Texas Intermediate and Brent), natural gas, gasoline, and heating oil.
- Metals: This category is further divided into two groups.
- Precious Metals: This includes gold, silver, and platinum. These metals are often seen as “safe haven” assets. Investors tend to buy them during times of economic uncertainty or high inflation.
- Industrial Metals: This includes metals like copper, aluminum, and zinc. These are the essential materials used in construction and manufacturing. The demand for these metals is often a strong indicator of the health of the global economy.
Soft Commodities
These are resources that are grown or raised, rather than mined.
- Agriculture: This includes all the staple crops that feed the world and are traded on global markets. Common examples are corn, wheat, soybeans, rice, and oats.
- Livestock and Meat: This category includes commodities like live cattle and lean hogs.
- Other “Softs”: This is a broad category that includes many other grown commodities, such as coffee, sugar, cocoa, cotton, and orange juice.
Why Do People Invest in Commodities?
Investors are attracted to commodities for several key strategic reasons.
- Portfolio Diversification: This is the most important and powerful reason. The prices of commodities often move independently from the prices of stocks and bonds. Their prices are driven by different factors, such as weather patterns, geopolitical events, and global supply and demand. For example, during a stock market crash, the price of gold might rise as investors rush to safety. By including a small allocation to commodities in a portfolio, an investor can help to smooth out their overall returns and reduce their overall risk.
- A Hedge Against Inflation: Commodities are the raw inputs that are used to produce finished goods. When the price of oil, copper, and corn goes up, the price of gasoline, electronics, and food also tends to go up. This is a key driver of inflation. Therefore, owning commodities can be an effective way to protect your portfolio’s purchasing power during periods of high inflation. As the cost of living rises, the value of your commodity holdings may also rise.
- To Speculate on Global Trends: Some investors use commodities to make bets on global macroeconomic trends. For example, an investor who believes that a rapid global economic recovery is coming might invest in industrial metals like copper, in anticipation of a surge in manufacturing and construction.
How to Invest in Commodities
For an individual investor, there are several ways to gain exposure to the commodities market.
- Direct Physical Investment: You could, in theory, buy and store physical gold bars, barrels of oil, or bags of coffee. However, for most people, this is completely impractical due to the high costs of storage, insurance, and transportation.
- Commodity ETFs and Mutual Funds: This is the most common and accessible method for most investors. You can easily buy a share of a fund that is designed to track the price of a specific commodity, like gold or silver. You can also buy a broad-based commodity fund, which invests in a diversified index of many different commodities at once.
- Investing in Commodity-Producing Companies: Another popular, though indirect, way to invest is to buy the stocks of companies that produce commodities. For example, instead of trying to invest in crude oil itself, you could buy the stock of a major oil and gas company.
- Futures Contracts: This is a more complex method that is typically used by sophisticated and professional traders. A futures contract is an agreement to buy or sell a specific amount of a commodity at a predetermined price on a specific date in the future. This type of investing involves a high degree of leverage and is generally not recommended for beginners.
Conclusion
In conclusion, commodities are a unique and important asset class. They are the raw materials that fuel and feed the global economy. Their prices are driven by the most fundamental economic forces of all: global supply and demand.
For investors, commodities can play a valuable role within a well-diversified portfolio. They can provide a powerful hedge against the corrosive effects of inflation. Furthermore, their prices often move in different directions than stocks and bonds, which can help to reduce the overall risk and volatility of your portfolio. While you may not be trading barrels of oil or bushels of corn directly, understanding what commodities are and the role they play is essential. It gives you a more complete picture of the global financial markets. It also provides you with another powerful tool for building a truly resilient, all-weather investment strategy.