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Investing used to be a very simple process: keep enough cash on hand to cover immediate expenses, and then divide up the rest of your money between stocks and bonds, depending on how much risk you wanted to take and how long you had before you needed to spend your money.
Now, though, you'll find a bunch of new types of investments covering asset classes you may never have heard of before. In many cases, it makes sense to include these alternative investments in your portfolio. The question, though, is where they fit in a balanced investment strategy and what they should replace in your existing holdings.
Going beyond stocks and bonds
In the past 10 years, there's been a renaissance in investing. Going well beyond the traditional stock-bond divide, many new types of investments don't really fall into either category. Some of them straddle the fence between bonds and stocks, combining attractive elements of each. Others are simply in a class by themselves.
Let's take a look at several of the more popular alternatives and figure out where they should go in your portfolio.
1. Real estate investment trusts
REITs have been around for a long time, but they've gotten popular over the past 15 years or so. Originally, they were seen as a fixed-income alternative to bonds; because the tax rules governing REITs require them to pay out most of their income as dividends, they provide strong streams of dividend income to their shareholders. But during the real-estate boom, net asset values of REIT holdings rose substantially, making them valuable for their appreciation potential as well and therefore making them more closely resemble stocks.
In the post-bubble real estate world, different REITs serve different functions. Mortgage REITs like Hatteras Financial (NYSE: HTS ) and American Capital Agency (Nasdaq: AGNC ) are essentially bonds on steroids, providing strong leveraged income that's ultimately based on interest rates. But more traditional REITs that own actual properties rather than just mortgage-backed securities are more a play on real estate values and therefore look more like stocks.
REITs can reasonably make up 5% to 10% of a portfolio, taking the place of either bonds or stocks depending on which type of REITs you choose to buy.
2. Master limited partnerships
With oil prices on the rise, energy stocks have had strong returns lately. But for those looking to max out their energy-related income, master limited partnerships are a great investment.
Companies like Cheniere Energy Partners (AMEX: CQP ) and Buckeye Partners (NYSE: BPL ) own energy-related assets like pipelines, refineries, and natural resources themselves. Because of their limited-partnership structure, these investments take advantage of tax breaks like depletion and depreciation to pay out far greater amounts than their taxable income reflects. That leads to some high yields without the high-priced tax bill you'd expect.
Master limited partnerships can take the place of energy stocks on the equity side of your portfolio. With their income dependent on energy prices, they can be just as volatile as regular stocks, so don't let their high income fool you.
With the U.S. dollar in decline, many have flocked to commodities as a way to preserve value. Funds like Central Fund of Canada (AMEX: CEF ) have made buying gold and silver easy for stock investors, while other ETFs, such as United States Natural Gas (NYSE: UNG ) and PowerShares DB Agriculture (NYSE: DBA ) , open up an even wider range of possibilities for those interested in commodities.
The appeal of commodities stems from their independent price moves from stocks. Although the two asset classes have seen correlations rise recently, commodities can still create some diversification benefits for investors, but it's far from obvious where they belong in your portfolio.
In my view, commodities often take the place of stocks that track their movements. So if you invest in physical silver, you don't necessarily need to buy shares of silver miners -- or at least not as big an allocation as you might otherwise want. Treating commodities as analogous to stocks isn't strictly correct from a theoretical viewpoint, but for purposes of risk, it's not a bad way to think about them.
Mix it up
Alternative investments can be very useful in adding spice to a plain-vanilla stock and bond portfolio. As long as you don't get too carried away, the right sprinkling of alternative investments can enhance your returns and keep your overall risk in check.
Learn more about getting your investing plan together with our 13 Steps to Investing Foolishly. It'll get you on track to a great financial plan in no time.