The Pros and Cons of Investing in Commodities

The only bad question is the one left unasked. That’s the premise behind many of my recent articles. Each covers a different investment-related question that many people have but are afraid to ask.  In last month’s article, we discussed what it means to invest in commodities and how regular investors actually do so.  So, in this letter, let’s break down:

What are the pros and cons of investing in commodities?

As I covered in Questions #12, a commodity is a physical product that is either consumed or used to produce something else.  For example, corn, sugar, and cotton are all agricultural commodities.  Pork, poultry, and cattle are livestock commodities.  Oil, gas, and precious metals like gold and silver are commodities, too. 

A commodity is generally seen as an alternative investment.  Traditionally, large institutions and professional traders are the most likely to invest in commodities, but regular people can, too.  Like every type of investment, though, there are both potential benefits and risks that come with commodities.  Some of these are very specific to commodities. 

The Advantages of Investing in Commodities

Diversification

As you know, all types of investments will rise and fall in value at different times.  That’s why it’s important for portfolios to consist of diverse asset classes, each driven by different factors.  We refer to this as having low correlation, meaning price changes in one asset don’t affect the price of another asset.

Typically, commodities have a low correlation to stocks and bonds.  Every type of commodity is affected by different economic factors. Most of those don’t usually affect, say, stocks.  For example, while changing interest rates can have a major impact on stocks, they don’t have a direct effect on cotton prices.  And though a hurricane in the Gulf of Mexico can dramatically impact oil prices, it usually doesn’t mean much to the overall stock market.

For these reasons, investing in commodities can add valuable diversification to a portfolio. 

Diversification is important because it can help cushion your portfolio from major volatility. If one asset class takes a hit, the others could help compensate. However, it is important to note that diversification doesn’t eliminate risk.      

Hedge Against Inflation

During periods of high inflation, the price of most consumer goods and services will go up.  While that can make for an unpleasant-looking receipt at the grocery store, it can be a boon to commodity investors.  That’s because the price of many commodities tends to go up with inflation.  As a result, investing in commodities can help “hedge” – or lessen – the risk of investing in other asset classes that may be negatively affected by inflation. 

Potential for Significant Returns

Commodities can also – potentially – produce meaningful returns.  Certain types of commodities will occasionally rise drastically in demand, taking their price up with them.  As a result, investing in the right commodity at the right time can certainly help investors generate a significant profit! 

The Downsides to Investing in Commodities    

Volatility

Commodities can be extremely volatile.  As you’ve no doubt seen, the price of any commodity (say, oil, or gold) can fall remarkably fast if the demand for those products falls far below their supply.  For these reasons, you should only invest in commodities if you can afford to take on the…

Multiple Risks

As I mentioned, all types of investments come with risks.  However, the risks associated with commodities are particularly large and varied.  For example, some commodities – especially agricultural ones – are vulnerable to weather.  Others can be affected by natural disasters, military conflicts, or changing government regulations.  While these same factors can certainly drive prices up, they are also just as likely to drag prices down if the wrong conditions arise.  Furthermore, investors have no control over these types of risks…and they are notoriously difficult to predict in advance. 

No Income

Finally, commodities do not produce any income for investors the way bonds or dividend-paying stocks do.  So, investors seeking income – especially retirees – may find that the pros of commodities are just not worth the risks when it comes to fulfilling their needs. 

In the end, there’s simply no “one size fits all” type of investment, and that’s especially true of commodities.  While they can be a viable fit for some portfolios, every financial advisor must look carefully at whether commodities are right for their client’s needs, and whether the risks associated with them are more than they can afford. 

So, now you know the “how” and the “why” of investing in commodities.  In next month’s article, I’m going to demystify common investment–related jargon you may hear bandied about by the media.  In the meantime, have a great month!