For investors with appropriate risk tolerances, the measured inclusion of commodities can offer an additional dose of diversification.
Diversification is a cornerstone of thoughtful, long-term focused investing. Incorporating assets and asset classes that don’t always move in tandem – that is, their returns aren’t strongly correlated – can help temper stock and bond market risk.
For investors with higher risk tolerances and access, options to diversify beyond the traditional trio of stocks, bonds and cash may be appropriate. Along with other forms of non-traditional or alternative investments, this is sometimes pursued via the measured inclusion of commodities.
Commodities are basic goods such as energy products, precious metals and agricultural products – things that are essentially uniform in utility and interchangeable with other goods of the same type.
There are hard commodities that require mining or drilling, such as metals like gold and aluminum, as well as energy products such as crude oil, natural gas and unleaded gasoline. Then there are soft commodities, those that are harvested or ranched, such as corn, wheat, soybeans and cattle.
Copper is an industrial commodity that is looked to as a gauge of growth in the economy.
Investors and traders have several ways to buy and sell commodities: in the market at today’s price called the Spot Price or via forwards, futures and options which allow delivery in the future instead of today. Commodities can be bought and sold on exchanges and derivatives markets, and there are also commodity ETFs and mutual funds.
Many factors can sway the price of commodities: droughts, government policies, international events, global recessions, consumer preferences, fluctuating input costs and, of course, supply and demand.
For example, the oil market is currently in backwardation with spot prices higher than forward. The market is pricing in a 10% decline in oil prices between now and the end of 2023. This does not mean it will happen, but it does indicate what the market is pricing in.
Because of these factors, volatility tends to be higher with commodities than with stocks, bonds and other assets. Some commodities may show more stability than others, such as gold, which serves as a reserve asset for some central banks – yet even gold becomes volatile at times.
Over the past half-century, commodity prices have undergone different cycles. Since 1996, global macroeconomic events have been the prime source of price volatility. However, between 1970 and 1996, supply shocks specific to commodities such as oil sparked volatility.
Recessions have often been associated with weak demand and disruptions in supply, which work in tandem to depress commodity prices. In 2020, the global recession triggered by the COVID-19 pandemic led to a widespread decline in commodity prices, which was followed by a sharp rebound in prices. Such increases and decreases in commodity prices have been common in recent decades.
Commodities had a challenging bear market up until recently. Potential recessionary trends are risks that could delay commodities’ rebound.
In the coming years, the potential transition from fossil fuels could also cause far-reaching shifts in the supply-and-demand pattern for commodities.
As investors increasingly consider commodities a financial asset, commodities’ value as portfolio diversifiers – particularly during extreme market stress – has diminished relative to historical expectations. However, while commodity profiles may not be what they were, they may still have a place in a diversified portfolio.
During periods of inflation, commodities could continue to provide diversification and deserve consideration in portfolios designed to navigate varying market environments. Since their prices have typically risen when inflation is accelerating, they may offer preservation from inflationary effects. In fact, commodities themselves are a major part of most inflation indexes. It makes sense that their prices tend to rise when inflation is increasing.
As the demand for goods and services increases, the price of goods and services rises as does the price of the commodities used to produce those goods and services. Futures markets are thus used as auction markets and clearinghouses for the latest information on supply and demand.
Another characteristic of commodities is that they have not been highly correlated to traditional asset classes like stocks and bonds. Since their prices depend only on the balance of supply and demand, they can be used to attempt to diversify an investment portfolio.
It should be noted though that this simplified relationship between commodity prices and inflation has waned over time. In the 1970s, the relationship was statistically robust. However, in the past 30 years, this correlation has become less significant. But commodity prices have performed well overall as an indicator of inflation when other factors influencing inflation, like employment and exchange rate fluctuations, were apparent.
For these reasons – an inflation hedge and non-correlation – many financial professionals recommend allocating from 5% to as much as to 10% of a portfolio to commodities. Of course, investors with a lower risk tolerance may want to consider a smaller allocation.
While commodities can and have offered attractive returns in the past, they are still one of the more volatile asset classes. Your advisor can help evaluate whether adding commodities to your portfolio could be appropriate based on your risk profile, current asset allocation, diversification needs and overall financial goals.
This is not a recommendation to invest in commodities and you should consult with your financial advisor for advice based on your personal situation, financial goals and objectives. Past performance may not be indicative of future results. Diversification does not guarantee a profit nor protect against loss. Commodities are generally considered speculative because of the significant potential for investment loss. Commodities are volatile investments and should only form a small part of a diversified portfolio. There may be sharp price fluctuations even during periods when prices overall are rising. Raymond James is not affiliated with any organizations or individuals mentioned.