(MONEY Magazine) – At long last, after years of inching out from under a boulder of mortgage debt, my wife and I paid it off earlier this year. That made me wonder: Now that we own our house free and clear, should we rethink our portfolio? For that matter, whether you have a mortgage or not, how should you take your house into account when figuring out what to do with your investments?

After all, if you had 27% of your money in a single stock, you would want to adjust the rest of your portfolio around that concentrated dose of risk; you might buy bonds or other stocks that have tended to go up when your favorite stock has gone down. No responsible financial planner would ever let a client keep 27% in one investment without seeking to hedge against the risk of being so narrowly focused.

And on average, according to the Federal Reserve Board's 2001 Survey of Consumer Finances, Americans have 27% of their assets in their own home--more than in stocks, mutual funds and retirement accounts combined.

Since the basic rule of diversification is to never put all your eggs in one basket, you need to make sure your eggs are balanced across all your assets--not just stocks, bonds and cash. Warns Laurence Siegel, director of investment policy research at the Ford Foundation: "Your real estate portfolio, consisting exclusively or mostly of your house, is much more undiversified than your general stockholdings and needs more 'help' from diversifying assets." A renter with a single mutual fund might have a safer overall portfolio than a homeowner who has 27 stocks or six mutual funds; the value (and risk of loss) in that home can vastly outweigh all those other investments. So to a homeowner, "hedging" ought to mean more than just planting a few bushes out back.

Home economics

But this puzzle is trickier--and the solutions more subtle--than I realized.

If you want to protect against the risk of losing money on your house, lots of experts recommend buying a real estate investment trust or a mutual fund that bundles together many such REITs. That way, if your home in Sunnyvale, Calif. loses value, you will have a stake in other properties that might go up--say, office buildings in Kansas City or shopping malls in Miami.

On the other hand, say Stanford finance professor Steven Grenadier and economics consultant Peter Bernstein, owning your own home is probably plenty of real estate risk already.

Who's right? To solve the puzzle, let's figure out where your house fits in. An investment is anything that you can reasonably expect to produce predictable income. Bonds earn income through interest payments. Stocks generate dividends or, if you're lucky, capital gains when you sell. But it's hard to get income from a house while you live in and own it. To raise cash, you generally have to rent your home out, refinance it or sell it.

Some people "flip" houses, selling one after another in hope of consistent gains; others must sell to relocate or to divide family assets. Such folks definitely need to hedge against the risk of falling housing prices. Historically, bonds have tended to go up when home values go down. If you plan to sell a house anytime soon, then I think putting at least 20% of your money in a low-cost, high-quality bond fund is a prudent hedge. (Use shorter maturities that won't plunge if interest rates rise.)

How to weigh a house

If you plan to own rather than sell, it's a different story. Hans Nordby, a strategist at Boston-based Property & Portfolio Research, explains, "Individuals need to ask, 'What is my house?' For many people, it's a place where they live and stay until they go out feet first, not an asset for creating future cash flows. It isn't an investment; it's not a source of retirement income; it's a home."

As Peng Chen, director of research at the financial data firm Ibbotson Associates, puts it, "Typically, your primary residence is a form of consumption, not an investment." As with your car, most of the return on your house probably comes from using it, not from tapping it for cash. (Stanford's Grenadier points out that homeowners earn "savings from not renting," but that's not the same thing as an investment return.)

So it seems that a small stake in REITs or REIT funds might not be a bad idea for a homeowner, after all. Such an investment can be especially useful early in the life of your mortgage, says Siegel of the Ford Foundation. At that point you have little equity, and the bank is the true owner of "your" home. So putting 5% to 10% of your assets into REITs or REIT funds makes good sense.

But that's plenty of property for most folks. And shop carefully. Some REITs concentrate on one geographic region (Washington REIT owns properties in or near the nation's capital, while Prime Group Realty Trust focuses on the Chicago area). If you live in the same region, a localized REIT is not for you. Others specialize in one type of real estate; if you own your own home, stay away from REITs that own residential property, like Avalon Bay Communities or Town & Country Trust.

That's why REIT funds--which combine dozens of different REITs--are a better solution for most of us. Columbia Real Estate Equity and Vanguard REIT Index are two good funds with low overhead.

REIT funds aren't wallflowers anymore. In February, according to Lipper, real estate mutual funds took in a record $1.1 billion, thanks to their 37.2% average return in 2003.

But such a hot streak is the wrong reason to invest. Instead, decide how you want to divvy your assets up among stocks, bonds and real estate. Let's say you want a third of your portfolio in each. If your home equity (current market value minus your mortgage) is less than a third of your total assets, then a REIT fund would be a good way to get up to that level. That's the best reason to invest in one. Let somebody else get burned trying to grab on to a hot streak.

E-mail Jason Zweig, editor of Benjamin Graham's The Intelligent Investor, at investor@moneymail.com.