What Are Commodities in Investing?

Even if you’re new to investing, you probably already know that investing through a diversified portfolio can help you minimize volatility and risk.

What you might not know, though, is that diversification doesn't have to mean just stocks and bonds. There are a lot of different types of investments you might consider adding to your portfolio, each with its own pros, cons and risk profile. Commodities are one such asset class.

But what, exactly, is a commodity? How do you invest in one? And what are the benefits (and potential drawbacks) that come with investing in it? Below, we answer these and other questions so that you’ll be better prepared to decide whether or not commodities belong in your portfolio.

What are commodities?

A commodity, broadly speaking, is any naturally occurring raw material that is used in the production of a finished product. Examples of commodities include precious metals like gold and silver, agricultural products like wheat and coffee, and fuels like gasoline and oil.

In investing, commodities are considered a type of alternative investment because they are not a stock or a bond. They are commonly added to an investment portfolio for diversification and because they can be an effective hedge against inflation.

Commodities and supply and demand

The price of commodities is heavily influenced by the basic economic law of supply and demand. If demand for a particular commodity increases while supply stays the same, it will cause the price to rise. The same is true if demand stays the same while the supply shrinks. But if demand decreases while supply stays the same, the opposite is true: The price will typically fall.

Types of commodities

Commodities can typically be further broken out into two broad buckets: hard commodities and soft commodities. Here are the differences between the two.

Hard commodities

Hard commodities are any natural resources that must be drilled for, mined or otherwise extracted from the earth. This category includes things like these:

• Precious metals: Gold, silver, platinum, palladium

• Industrial metals: Copper, aluminum, zinc, nickel, tin, lead

• Fuels: Crude oil, gasoline, heating oil, natural gas, coal

Soft commodities

Soft commodities are raw materials that are directly or indirectly cultivated by humans. This can include things like the following:

• Grains: Corn, wheat, soybeans, rice

• Livestock: Cattle, hogs, leather, wool, dairy

• Softs: Cocoa, coffee, sugar, cotton

• Lumber: Wood

Hard versus soft commodities

The primary difference between hard and soft commodities is the fact that hard commodities are finite resources, while soft commodities are not.

Earth contains only so much gold or oil; once all of the reserves of a particular hard commodity have been discovered and extracted, the commodity is gone.

Soft commodities, on the other hand, are products of human labor. In theory, the supply of a soft commodity like corn or wheat is limited only by the amount of land and other resources (like water and fertilizer) that can be dedicated to growing it.

How to invest in commodities

If you’re interested in investing in commodities, there are a number of ways you can go about doing so; some may be better suited to individual investors, while others are better suited to larger organizations.

Buying physical commodities

When you buy physical commodities, you actually take direct ownership of the goods with the intention of selling them at a profit in the future. Because this option requires you to physically store the goods, it’s not practical for most individual investors.

The one caveat? Precious metals like gold and silver, which can be bought and sold by the coin, ingot or bar, can be relatively easy to store—though this may be cost prohibitive for many.

Investing in futures

A futures contract is a type of derivative that allows an investor to speculate on the future price of a commodity. It makes it possible for individual investors to invest in commodities without actually having to purchase (and store) them.

That said, futures contracts can be extremely complicated, typically making them too confusing and volatile for the average investor.

Investing in stocks of commodity producers

Many of the companies involved in the production of commodities are publicly traded companies, whose shares can be bought and sold on the stock market. This can be an indirect way of investing in commodities. If you believe that the price of gold is going to increase, for example, you may decide to invest in one or multiple gold-mining firms.

This is a much easier option for most investors, many of whom already have a brokerage account and may be familiar with buying and selling stocks.

Investing in commodity funds

A commodity fund is an exchange-traded fund (ETF) or mutual fund designed to track a particular commodity or basket of commodities. These funds can directly buy and hold commodities, futures or options. Similarly, some funds invest in a basket of commodity producers (above), providing greater diversification versus picking individual stocks.

A commodity fund is one of the easiest options for individual investors looking to add commodities to their portfolio.

Pros and cons of investing in commodities

Before making the decision to invest in commodities, it’s important to know the potential benefits and drawbacks.

Pros of commodity investing

• Commodities can increase diversification: The price of most commodities is not strongly correlated with the prices of other assets like stocks and bonds. This means that adding commodities to your portfolio can increase your overall diversification.

• Commodities can be an inflation hedge: During periods of high inflation, the prices of commodities tend to increase. This means that having a certain percentage of your portfolio dedicated to commodities can help preserve buying power when inflation rises.

• Commodities can lower the risk of other investments: Investing in commodities can make it possible to profit from market trends that hurt your other investments. For example, let’s say you own stock with a popular coffee chain. If the price of coffee beans rises, the coffee chain might suffer from higher prices, which will ultimately hurt the company’s share price. But if you are also invested in coffee beans as a commodity, the same price trends would benefit your commodity investment.

Cons of commodity investing

• Commodities can be extremely volatile: The price of commodities is dependent on supply and demand, both of which can be difficult to predict over the long term. Everything from geopolitical conflicts to extreme weather to supply chain issues can affect commodity prices, sometimes in surprising ways, leading to high levels of volatility.

• Commodities can be complicated: Commodities trading comes with a steep learning curve that can be difficult for many investors, especially when it comes to things like futures contracts.

• Commodities don’t produce income: Most income investors won’t be impressed with commodities for a simple reason: Unlike bonds and dividend stocks, they don’t passively produce income. To earn a profit from commodity investing, you’ll eventually have to sell the underlying asset.

How a financial advisor can help

Getting started with commodity investing can often feel overwhelming, especially if you’re not familiar with how the commodity market works or what options are available. The good news is that you don’t have to go it alone.

A financial advisor can help you understand what role, if any, commodities might play in your portfolio. They’ll ask questions to try to understand your investing goals and timeline, helping you build a comprehensive plan to help you achieve your goals.

Investments carry risk including potential loss of money invested and no investment strategy can guarantee a profit or protect against loss.

Northwestern Mutual (NM) and its Financial Representatives provide access to ETFs and/or mutual funds that invest in commodities. NM and its Financial Representatives do not sell or provide direct investing in Commodities.