Using Alternative Investments in Your Portfolio

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There's more to investing than plain old mutual funds. Are today's alternative investments right for you?

Given the amount of attention they receive in the investing media these days, it's not surprising that there's so much interest in alternative investments now. However, I would caution you to go slowly here: These are highly specialized investments and nearly all of them are designed for institutional investors (such as foundations and pension funds) or for experienced high-net-worth individual investors.

While there are occasionally big wins for alternative investors, when we asked the Armchair Millionaire community, it was the horror stories that seemed to catch our eye, such as:

Drilling for Oil: "I invested in some oil wells quite a few years back and it was a fiasco. Did not do my research, was totally not in the know about anything investment wise at that time. I took a loss on my taxes (I think), but have since stayed away from things I do not understand or do not have the time to really research." --Mom2two

To begin exploring alternative investments, you need to have an idea of what's available. Here are some of today's hottest alternative investments:

•    Hedge funds. Hedge funds are like mutual funds in that they invest in a variety of investments. However, they are exempt from many of the rules that govern mutual funds, enabling them to use a range of strategies (such as using leverage and selling short) that are unavailable to mutual funds.

•    Registered funds. These are closed-end funds that invest in hedge funds. Their structure makes them somewhat more accessible to some advisors than investing directly in a hedge fund.

•    Private equity funds. These typically invest in private companies (such as providing financing for start-ups). As a result of their investments, private equity funds often have a large ownership stake in the companies and may take an active role in managing the companies.

If you decide to take an alternate route, my guide will help you sort out what's optimal for you.

The Armchair Millionaire's Guide to Evaluating Alternative Investments

Is it cost-effective? It is typical for alternative investments to have fees and expenses that are considerably higher than mainstream investments. If these costs outweigh your profits, they are obviously not worth it.

Do you understand it? Many alternative investments are complicated, to say the least. They use sophisticated strategies to try to achieve their goals--strategies that may require a degree in finance to fully comprehend. If you don't have at least a basic understanding of how the investment works, best to steer clear.

Will it throw your portfolio off balance? Most alternative investments come with high minimums, typically starting at $100,000 to $250,000. If you have to move your entire portfolio into the investment in order to make the minimum, you'll foul up your asset allocation.

Can you absorb the loss? While an alternative investment might provide wonderful grist for cocktail party conversations, you should invest only if you have a clear investment objective and you can handle the loss of the investment in its entirety.

THE BOTTOM LINE: Just because you have enough money to invest in alternative investments doesn't mean you should. Weigh risks, costs and potential returns very carefully before you stray from a common sense portfolio of historically proven investments.

This column appears each week on CNNMoney.com, the Web sites for CNN and Money Magazine.

Syndicate this weekly column in your publication or Web site: http://www.armchairmillionaire.com/weeklycolumn

ArmchairMillionaire.com was founded in 1997. The company's first book, The Armchair Millionaire, was published in 2001. Today, http://www.ArmchairMillionaire.com is an established community of common sense savers and investors.

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Lewis Schiff