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How Much Should You Have in Alternative Investments?

Dan Caplinger
April 19, 2011

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 inc