The proper allocation for a hot sector. By Jeffrey R. Kosnett, Senior Editor November 6, 2007 Steve Sutton regularly rebalances his portfolio. Earlier this year, he cut his allocation to real estate stock funds by half after they had appreciated so much that they represented 10% of his combined IRA and 401(k) retirement portfolio. Steve, who lives in Charlotte, N.C., invested most of the proceeds in Fidelity Select Natural Resources, which owns a variety of energy stocks -- from ExxonMobil to manufacturers of wind turbines.That was a reasonable move. Steve, 49, is divorced and hopes to retire from his job in commercial software sales before he's 60, so he needs more growth. All told, he has about 60% of his retirement money in stock funds -- about half in funds that invest in shares of large domestic companies and one-fifth in foreign-stock funds. Among his holdings are such fine funds as T. Rowe Price Equity Income, T. Rowe Price Growth Stock and Dodge & Cox International Stock. The rest is scattered among small-company-stock funds and sector funds. Good question Steve should boost his allocation to stock funds to about 75%. But his real question is whether his position in Fidelity Natural Resources, which now represents 3% of his retirement kitty, provides enough exposure to the energy sector. Given widespread expectations that prices for oil and gas have nowhere to go but up (not to mention the fund's five-year annualized return of 33%), it's a good question. Pros often advise investors to place 5% or so of their money in real estate securities and at least 15% to 20% in foreign stocks. But you'll rarely hear one say that an investor should have this or that amount in energy stocks. That's because the experts consider energy a market sector rather than a separate asset class. The logic, says Eileen Neill, a managing director of index keeper Wilshire Associates, is that the movements of oil-and-gas stocks correlate closely with the overall market and therefore don't provide the diversification benefits of gold, real estate and bonds. Advertisement The logical approach is to compare your oil-and-gas holdings with their position in the total market. Energy stocks are currently a 12% weighting in Standard & Poor's 500-stock index and a 10% position in the Dow Jones Wilshire 5000 index, which measures the entire U.S. market. Both those figures may understate energy's true role in the economy. Big conglomerates, such as General Electric and United Technologies, derive a substantial amount of business from energy-related sales. So do railroads and, increasingly, agribusinesses. Branch out Using Morningstar's Instant X-Ray tool, we find that 11% of Steve's stock portfolio is directly in energy companies, even after the addition of the Fidelity fund. We can also see that large oil-and-gas companies dominate his holdings. Five of the funds hold ConocoPhillips, four own Valero and Schlumberger, and three have stakes in ExxonMobil and Chesapeake Energy. Steve can justify boosting his energy allocation to 15% of his investments -- but only if he's not investing in more of the same. A solution is to switch 3% to 5% of his bonds and cash kitty to small and midsize exploration-and-production companies. Either of two exchange-traded funds, iShares Dow Jones U.S. Oil and Gas Exploration and Production (symbol IEO) or ProShares Ultra Oil and Gas (DIG), would energize Steve's portfolio.