Don't Get Swept Up in Commodity Rally

I recently stumbled across a headline proclaiming that commodities had logged their biggest gains since 1990. All of this excitement has brought out the extrapolators.

They're the ones who predicted oil would hit $200 a barrel after reaching $147 last summer. When crude sank to $35, these people said it would drop to $25. When gold flirted with $1,000 an ounce, they said prices would top $1,200. It's easy to get carried away.

If you're a long-term investor who has an average tolerance for volatility and believes in asset allocation, you should have a stake in commodities. While some investors put 20% of their portfolios in gold, I think a smaller weighting of 5% to $6% makes more sense. That's because a lot can go wrong with commodities and they might not follow the patterns you expect.

Take a look at the performances of the PowerShares DB Commodity Index Tracking Fund(DBC Quote) and the S&P 500 Index since the end of 2007, when stocks started to decline.

DB Commodity Index ETF vs. S&P 500 Yahoo! Finance

For the first nine months of the bear market, the DB Commodity Index ETF rose dramatically as equities churned lower. When the extrapolators predicted $200 oil prices, the fund fell 60% as stocks lost 45%.

At first, commodities offered the zigzag effect that investors expected. But when the economy worsened, the fund started to move in the same direction as stocks. The benefit of owning the DB Commodity Index ETF early in the bear market was erased.

Most of the time, commodities do what they're "supposed to do" but occasionally prices correlate with stocks as they did last summer. When things were at their weakest point, a large weighting in commodities would have magnified the decline.