Any savvy investor knows that you can't put all your eggs in one basket. Even though it may not cut out risk entirely, diversifying your investment portfolio can help you reach your investment goals by maximizing your returns.

There are plenty of different investment vehicles for you to choose from including stocks, bonds, mutual funds, futures, and currencies. These can be broken down even further, grouping together assets that share characteristics: large-cap stocks, financials, and government bonds are just a few examples.

And don't forget commodities. These are basic goods that can be transformed into other goods and services. There are a number of different commodity investments for both new and experienced traders. But before you head out to make the leap, here are a few important things you need to know about commodity investing, including the best ones to consider.

Key Takeaways

  • Investing in commodities can provide investors with diversification, a hedge against inflation, and excess positive returns.
  • Investors may experience volatility when their investments track a single commodity or one sector of the economy.
  • Supply, demand, and geopolitics all affect commodity prices.
  • Investors can trade commodity-based futures, stocks, ETFs, or mutual funds, or they can hold physical commodities like gold bullion.
  • Three of the most commonly traded commodities include oil, gold, and base metals.

What Is Commodity Investing?

Commodity trading goes back centuries, even before stocks and bonds exchanged hands. It was a very important business, linking different cultures and people together. From spices and silks in the early days to the exchanges where these assets are now traded, commodities are still a popular investment vehicle.

Investors hoping to get into the commodity market can do so in several different ways. Commodity-hungry investors can consider investing directly in the physical commodity, or indirectly by purchasing shares in commodity companies, mutual funds, or exchange traded funds (ETFs).

Benefits

One of the biggest benefits of investing in commodities is the fact that they tend to protect investors against the effects of inflation. Generally, demand for commodities tends to be high during periods of high inflation, which pushes up prices. It's also a good bet against the U.S. dollar; so when the greenback declines, commodity prices rise.

Aside from the benefits of diversification, there is the potential to maximize returns with commodity investing. Although commodity prices are subject to fluctuations in the market through exchange rates, interest rates, and the global economy, global demand is strong. This has an overall positive impact on the stocks of companies that deal specifically with commodities, which can translate to positive returns for investors.

Unique Risks

One thing to keep in mind is that commodities tend to be much more volatile than other kinds of investments, especially funds that track a single commodity or a specific sector of the economy.

Futures are heavily regulated by the Commodity Futures Trading Commission (CFTC)

Investors who trade futures should remember that it involves speculation. Futures contracts involve tracking an underlying commodity or index. This could have an impact on the performance of the contract and, thus, give the investor a negative (or positive) difference. Futures also come with their own set of unique risks that must be managed independently of the underlying commodity.

Pros
  • Protect against inflation

  • Diversify a portfolio

  • Hedge against a decline in the base currency

  • Help hedge price risk

Cons
  • Increased volatility when compared to other investments

  • Margin trading in commodities potentially resulting in significant losses

  • Speculative nature of trading with uncertainty of the outcome

Crude Oil

As noted above, there are many different ways investors can choose to invest in commodities. If you have crude oil in mind, it helps to know what shapes prices and how you can invest in this commodity.

After production, crude oil is refined into many different products including the gasoline we use to fuel our vehicles. But it goes beyond just gas. Products made from petroleum include plastics, medicines, linoleum, shingles, ink, cosmetics, synthetic fibers, solvents, fertilizer, asphalt, and thousands of others.

But what affects prices? Crude oil generally reacts to the laws of supply and demand. The higher the demand, the lower the supply. When that happens, prices tend to rise. When demand wanes, supplies are fairly consistent, leading to a drop in prices. For instance, when gas is in high demand—say, during the summer driving season—the price at the pumps rises, translating into higher crude oil prices.

Similarly, demand from developing nations like China and India—whose economies are still growing—is also pushing up prices. Geopolitics also has a big impact on the price of crude oil. Tensions in the Middle East, where much of the world's oil is produced, can send oil prices skyrocketing.

How to Invest in Crude Oil

Investing in physical crude oil isn't as easy as other commodities; you can't just buy a barrel of oil. As an investor, you may consider futures; the most direct method of owning the commodity outright. But futures can be highly volatile and need a good deal of capital. And they also require a lot of knowledge, so it's not really a good option for novice investors.

Investors may consider purchasing stocks in oil companies, crude oil mutual funds, or even ETFs. These vehicles trade on exchanges just like stocks, so they're easy to come by. The U.S. Oil Fund is one example. It tracks the movement of West Texas Intermediate light, sweet crude oil.

Other options include buying shares in mutual funds or energy sector ETFs, which invest directly in oil company stocks. These options tend to come with lower risks because they have more diversified offerings.

Gold

The gold market boasts diversity and growth. It's used in jewelry, technology, by central banks, and investors, giving rise to its market at different times within the global economy. The precious metal has traditionally been a safe investment and a hedge against inflation. When the U.S. dollar goes down, you can bet gold prices will go up.

Just like crude oil, when there's an increase in demand, the same happens to the price of gold. Furthermore, prices are affected when central banks—which hold gold—decide to diversify their monetary reserves by buying more gold.

How to Invest in Gold

Unlike crude oil, investors can take possession of the physical commodity. Investors who want to hold the physical commodity can do so by purchasing gold bullion bars or coins. But this means having to pay for a place to store it like a safety deposit box or a vault.

Another option, just like crude, is to go through the futures contract. Contracts require investors to deposit an initial margin. But again, there is a risk to this kind of investment. If the price rises, investors will profit. However, if the price drops, the investor stands to lose their money.

Stocks and ETFs, along with mutual fund options are aplenty. With gold stocks, investors aren't just limited to producers, but also to exploration and mining companies. As usual, it's a good idea for investors to do their homework and see what the operational risks are for each company.

Gold ETFs, on the other hand, provide exposure to the precious metal while tracking its price. For instance, the SPDR Gold Share ETF gives investors exposure to bullion without having to take possession of it.

Base Metals

Base metals are common metals used in commercial and industrial applications, like construction and manufacturing. Aluminum, zinc, and copper are good examples. They are relatively inexpensive, and supplies are generally stable because they're commonly found around the world. But because they are plentiful, prices tend to be much lower than precious metals. However, the increase in the applications of base metals coupled with rising global demand—particularly from China and other developing nations—continues to positively impact prices.

How to Invest in Base Metals

Holding on to aluminum, zinc, and copper may not necessarily be very fruitful, Because of their prices, investors would have to hold copious amounts of these commodities in order to profit. Instead, holding stocks in base metals companies like aluminum company Alcoa or a steel company like U.S. Steel is a great way to get a foot in the door. Furthermore, holding ETFs like the SPDR Metals & Mining ETF provides exposure to companies involved in metals and mining.

How to Buy Commodities FAQs

What Is the Best Way to Invest in Commodities?

The best way to invest in commodities is through commodity exchange traded funds (ETFs). ETFs allow for ease of trading as they are purchased like stocks, provide diversification, are not traded on margin like futures, and typically have low expense ratios.

When Should You Buy Commodities?

There is no specific time that constitutes the best time to buy commodities. Commodities are a hedge against inflation, so buying before periods of high inflation is a good investment strategy. However, it can be tough to predict when inflation will occur and most developed economies don't experience high levels of inflation anymore.

A commodity should be viewed as any other investment, taking into consideration an investor's time horizon and risk profile. Buying a commodity when it is at a low price and its future outlook appears strong based on fundamentals is always a good time to buy for a long-term horizon.

How Do I Buy Oil Commodities?

An individual can buy oil commodities by either purchasing an oil commodity ETF, buying the shares of oil companies, or buying oil futures through a brokerage account.

Are Commodities a Good Investment?

Like any investment, commodities can be a good investment but also come with risks. An investor needs to understand the markets of the commodity they wish to trade in, for example, the fact that oil prices can fluctuate based on the political climate in the Middle East.

The type of investment also matters; ETFs provided more diversification and lower risks where futures are more speculative and the risks are higher because of margin requirements.

That being said, commodities can be a hedge against inflation, and gold, in particular, can be a hedge against a market downturn.

How Do I Start Commodities Trading?

You can start trading commodities by opening a brokerage account and purchasing shares in the commodity-specific company of your choice or a commodity ETF after you have done your research and determine the specific investments that are right for you.

The Bottom Line

Commodities come with their own risks like any investment but can be a good way to diversify your portfolio if you understand the various aspects of the commodity you choose to invest in.

In addition to the commodities mentioned above, other commodities to consider are other precious metals—platinum, palladium, silver—lithium, cotton, and food products such as coffee, corn, oats, wheat, soybeans, and sugar. But as with all investment decisions, though, do your own research or consult with an experienced broker.