What are commodities? Tangible, everyday goods you can invest in, to hedge against inflation or sinking stock prices

• Commodities are publicly traded tangible assets, agricultural products and natural resources used in commerce and trade.
• Though highly volatile and high-risk, commodities can act as a counterweight to stocks and bonds and a hedge against inflation.
• Investors can own commodities outright, but most buy commodity-related stocks or funds, or options on commodities futures contracts.

When most people think of investing, they usually think of stocks and bonds. But you can also invest in tangible goods and substances. Known in the financial world as commodities, they're often made up of the things you use or consume every day - from foodstuffs to gasoline to metals.

Commodities happen to be one of the oldest forms of wealth and investing, far predating stock exchanges and bond markets. In fact, the strength of many civilizations and countries has been linked to the buying and selling of commodities. The spice trade literally shaped the modern world. The animals, textiles, and jewels moving along the Silk Road to market forged ties between Europe and Asia. The Vikings set sail to lands in search of grains and livestock.

Commodities have financed societies and helped them grow. The ancient Greeks and Romans used gold as a currency. Hundreds of years later, in the 19th century US, the Gold Rush more than tripled the population of California.

Today, commodities are considered an alternative investment, while relatively newfangled paper assets are considered the traditional ones. Still, they can play a key part in your portfolio. According to Trina Patel, a financial advisor at Albert, "commodities tend to have a low to negative correlation to stocks and bonds" - that is, their prices generally move in the opposite direction from these securities.

For this reason, many investors turn towards commodities when the stock market has a poor outlook, or just to diversify their holdings.

Here's what you need to know about commodities, how they work, and how to invest in them.

What are commodities?

Commodities are tangible goods that can be traded for other tangible goods or cash. They're commercially sold products that you can buy (think: the coffee you brew in the morning or the gasoline you put into your car). The financial world splits commodities into two major categories: hard and soft.

Within the hard and soft categories, there are four different groups of commodities that contain a wealth of different individual products:

• Energy: This includes crude oil, heating oil, gasoline, and natural gas. As oil is a limited global supply, prices have historically increased with demand, though it's a largely volatile commodity affected by an economic downturn, regulations from the Organization of the Petroleum Exporting Countries (OPEC), and the shift towards renewable energy sources.
• Metals: This includes both industrial metals and precious metals. Gold, which falls into the latter category, is one of the most popular metal commodities because it's one of the most stable in value. Many investors choose to invest in precious metals when stock prices are falling. Other metal commodities include silver, platinum, aluminum, tin, and copper.
• Agriculture: This sector includes crops, with some of the most popular being corn, soybean, wheat, sugar, and coffee. Overall, these commodities are subject to weather, natural disasters, and disease, but can be profitable in the face of population growth and limited food supply.
• Livestock and meat: This includes animals and animal products like live cattle, feeder cattle, live hogs, pork bellies, and milk. This sector faces many of the same constraints and benefits as agriculture.

How commodities are traded

Like stocks, commodities trade on public exchanges, their fluctuating prices posted openly. Exchanges either specialize in a particular group of commodities or offer several different types. commodities. For example, the London Metal Exchange (LME) specializes in metals, while the Chicago Mercantile Exchange (CME) trades agriculture, energy, and metals.

Also like stocks, commodities' performance is often tracked in indexes. The three of the most widely used commodities indexes in the United States are:

• S&P GSCI index
• Bloomberg Commodity index
• DBIQ Optimum Yield Diversified Commodity index

What influences commodities prices?

Overall, commodities are typically considered high-risk investments. Their prices are driven by supply and demand, which of course also affects stocks. But, unlike stocks, commodities are affected - literally - by external, unpredictable elements like weather and natural disasters.

For example, in 1996, Hurricane Bertha swept through North Carolina, damaging 60% of the state's corn crops. As much as 20% of the crop saw its yield cut in half. As a result, corn prices skyrocketed from $2.56 per bushel in May 1995 to a high of $4.77 per bushel in May 1996.

Commodities are also tied to politics and the macroeconomy. For example, between 1973 and 1974, crude oil prices spiked from a low of $3 per barrel to a high of $12 when Arab oil producers imposed an embargo to punish the West for supporting Israel in the October 1973 Yom Kippur War against Egypt and other Arab nations.

In April 2020, the opposite happened. For the first time in history, the value of crude oil plummeted into negative numbers after the novel coronavirus pandemic decimated demand and suppliers struggled to store their oversupply.

Why invest in commodities?

Just because commodities are vulnerable to a variety of risks, that doesn't mean they're a bad investment. In fact, they can be quite profitable as long as you have the right strategy - and can watch the markets.

Advantages of commodities

• Diversity: Acting as a counterbalance to stocks, commodities can be used to add diversity to a portfolio, which helps mitigate overall risk.
• Inflation hedge: The price of commodities generally rises with inflation, while the value of a dollar shrinks. According to Adam Grealish, the director of investing at Betterment, commodities provided an annual return of .06% between 1802 and 2013, which is slightly more than the average savings account today. During that same period, a dollar suffered an annual loss of 1.4%.
• Variety: Not all commodities are equally volatile. Metals like gold or silver generally have a more stable value than a crop that could be affected by drought or livestock that could face widespread disease.

Drawbacks of commodities

• Illiquid: Directly owning most commodities is time consuming, difficult, and expensive.
• Volatile: Commodities prices are highly impacted by external risk factors, including political events and natural disasters.
• No income: Commodities don't pay dividends or interest. Their return is based on a rise in their price.

How to invest in commodities

There are a few different ways you can invest in commodities.

Direct ownership

One of the simplest ways to invest in a commodity is to buy it directly. You don't need to use a third party, and you can easily find a dealer, purchase what you want, and re-sell it when you don't. Many dealers will even buy back their stock.

However, this approach doesn't work with every type of commodity. Dealing with a precious metal like gold can be relatively simple since it's among the more liquid commodities, available in coins.

Direct ownership is a lot more complicated with large quantities of heavy - or living - things like cattle, crops, and drums of oil. When you get into the logistics of storage and shipping, many people bow out.

Futures contracts and options

Since it's expensive to transport heavier materials like oil, metals, and agricultural products, commodities are often bought and sold as futures contracts. Futures are a legal obligation, in which someone agrees to buy or sell a commodity on a specific date at a specific price.

Generally, you'll see hedge funds or professional traders try to buy a commodity in the futures market hoping that the spot (or current) price of the commodity will rise, and the seller will be locked into honoring their obligation at the old, lower price. In turn, the hedge fund can flip the future for a profit.

Futures contracts can cost tens of thousands of dollars, though, and highly speculative: You can guess wrong on the price move, and still be on the hook to buy the commodity. For individual investors, a safer move is often to buy options based on a futures contract. Similar to stock options, with these you have the right - but not the obligation - to follow through on the transaction by the specified date. This provides a way to profit but isn't anywhere near as costly.

Commodity stocks

Instead of investing directly in a commodity, many people prefer to invest in companies that produce or process those commodities. It should be noted that a company's stock won't necessarily rise and fall exactly with the price of the commodity, though it is pretty heavily influenced by it.

You can get a feel for a company's financial outlook by examining its operations and contracts. For example, an upstream oil or gas company that's planning to expand into renewable energy may have more longevity than one that isn't. A company with high-yield, repeat contracts in place can be a safer bet than a company that's still establishing its client base.

Commodity ETFs and mutual funds

Commodity-oriented exchange-traded funds and mutual funds can provide diversity and a lower-risk, lower-cost way to get exposure.

These funds usually specialize in a particular type of commodity. Within that group, they may invest in one or a variety of commodity-related products like the physical commodity itself, futures contracts, and commodity stocks.

The financial takeaway

Though the idea of commodities as an investment is ancient, there's a reason they remain a store of wealth today.

As tangible assets, commodities prices generally move in the opposite direction to those of paper assets, like stocks. So they can act as a counterbalance within an equities-dominated portfolio, diversifying the total risk. For this reason, many investors turn towards commodities when stocks are sinking, like in the case of a bear market.

Other investors use commodities as a hedge against inflation. Remember, they are physical goods, so their value typically rises along with other climbing prices - while the value of a dollar, and what you can buy with it, shrinks.

Commodities are one of the oldest forms of investing, but also one of the most volatile. They offer no income - and no guarantee of appreciation. Any profit is based strictly on a price rise.

Nonetheless, you can find great rewards with a fine-tuned strategy that focuses on diversity and/or some of the more stable commodities. But it's particularly important to watch the markets - and even the weather. Because something as innocuous as an early frost has the ability to diminish your returns.

Related Coverage in Investing:

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What is diversification? A portfolio strategy that uses a variety of investments to limit risk

Trading and investing are two approaches to playing the stock market that bring their own benefits and risks

Beginner's guide to investing in gold: The major ways to buy and trade gold, and the benefits and drawbacks of each

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