The diversification gains equal or surpass those of other asset classes like fixed income and real estate. The main reason for this is their correlation, or lack thereof, to the stock market as represented by the S&P 500 (Correlation describes how similar the price movement is between two investments). Commodities have historically displayed absolutely no correlation whatsoever to the stock market or any of the bond market indices. In fact, they have a negative correlation. This non-similar pattern of performance allows an investor to minimize volatility and guard capital in down markets. Overall, these factors help to reduce overall risk in a portfolio of investments.
When commodities are used as a stand-alone investment, commodities are relatively volatile, exhibiting wild price swings. At times, they are also illiquid, keeping out the investor from exiting a position that is dropping rapidly. Another factor to be aware of when investing in commodities is the unusual income taxation. Mostly seen, investors are taxed each year on their share of the profits, if there are profits, regardless of whether the investment has been sold. This is a important disadvantage compared to investments in stocks, because one does not pay income taxes until the stock is actually sold. Also, in the occasion an investor invests in a commodity pool or partnership, it is very possible to owe income tax on interest income from the fund, even though the index may have had a down year. Lastly, fees to implement a commodities strategy are considerably higher than for those of mutual funds, for example. For these causes, it is best to reserve only a minor portion (15.0% or less) of one’s portfolio for this strategy.
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