Larry Swedroe is a principal and director of Research of BAM Advisors Services, and one of the leading financial advisors in the U.S. He is the author of the forthcoming book, "The Only Guide to Alternative Investments You'll Ever Need" (Bloomberg, 2008), a book that explains the role of commodities, REITs and other alternative assets in a portfolio. He spoke recently with the editors of HardAssetsInvestor.com about commodities, portfolio construction and the outlook for the U.S. stock market.

HardAssetsInvestor.com (HAI): A lot of people bought commodities over the past few years, and we've heard a lot of people are upset that they didn't perform as advertised, i.e., rising in a falling market. Should investors stick with commodities?

Larry Swedroe (Swedroe): A lot of people made big mistake with commodities. They thought that commodities hedged all the risk of equities. And a lot of people took the allocation they made to commodities from their fixed-income portfolios. That was a common mistake too.

The first thing you want to understand about commodities is that the reason to own them is to provide portfolio insurance. That's the only reason. You shouldn't buy them to enhance returns - no one can forecast returns or predict when commodities will produce strong absolute returns. You want to own them as portfolio insurance.

HAI: Which commodities are you talking about? Gold? Oil? Equities?

Swedroe: You don't want to own commodities directly, nor do you want to own the producers of commodities. The best bet is to own fully collateralized commodity futures that are not leveraged. We think the best vehicle is PIMCO CommodityRealReturn Fund, because they use TIPS as collateral, so you get a double real return in the portfolio. TIPS should have a higher real return than short-term T-bills, and because you have the inflation hedge, you don't need to worry as much about duration risk – you can go longer, which boosts your return.

If you assume PIMCO is going to keep an average TIPS range in the 10-year space, they will pick up an extra 1.5% in real return compared to a fund that holds 3-Mo Treasuries as collateral. TIPS also have negative correlations with equities, while 3-Mo Treasuries have zero correlation, so it's better hedge for your portfolio.

HAI: But what about the people who did all this … who bought commodities and bought the right commodities, and are still down big on the year?

Swedroe: It is again about understanding how commodities fit in the portfolio. There are 8 periods since the 1970s when stock returns have been negative. In six of the eight, commodities had positive returns when stocks had negative returns. And the average return during all eight periods, including the down ones, was plus 23%.

Commodities tend to have their best years when stocks do poorly. But they just have a tendency to deliver above-average returns when stocks deliver below-average returns, not a guarantee.

If you think about the two periods when both stock and commodity returns were negative, 1981 and 2001, those were two very bad deflationary-type recessions. We had demand shocks to the economy, and commodities got hit at the same time stocks got hit. The same thing is happening today. That is why you want to take the allocation to commodities from the equity side of your portfolio, because they can go down the same time as stocks. You need the fixed-income side of the portfolio to dampen the overall risk.

What's the best demand hedge? Long-term Treasury bonds. There are no periods when long-term bonds went down and commodities went down. By adding commodities and also extending the maturity of your bond portfolios, you gain some additional yield without increasing the risk of your portfolio, because those two assets hedge each other very well. That's the way to think about it. So many people think about assets in isolation, but you really want to think about it as part of a portfolio.

That's why I think you should still add commodities to a portfolio. Even this year, if you were rebalancing when commodities were sky-high, you're ahead. Really, even if you just held on to commodities, you're doing OK. The PIMCO fund is down 44%, and an all-equity portfolio that includes international is down that much or more. So it hasn't hurt you, and if you were rebalancing, you're probably well ahead.

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