NEW YORK (CNN/Money) - Don't set your sights too low when you start building your investment portfolio. Proper diversification doesn't just limit risk -- it can also boost your long-term returns.
|A 17-part series on how to achieve maximum returns for the right amount of risk. See all the lessons.|
The ideal portfolio contains investments that react to economic changes in opposite ways. For example, you can protect yourself against fluctuations in the price of oil by buying shares in both an electric utility and an oil producer. Higher fuel costs will hurt the utility but help the oil stock, while lower prices that hurt the oil stock will help the utility.
Such a move protects your portfolio against sudden shocks. But it also gives you cover to buy a few more aggressive stocks, which are likely to increase the long-term return of your overall portfolio.
Before putting this theory into practice, it helps to understand the business cycle. On average, the economy expands for three to five years and then contracts for 18 months or so. When there isn't a full-fledged recession, there's a slowdown known as a soft landing.
Most stocks do best when the economy is growing at a brisk clip, corporate earnings growth is accelerating and interest rates are falling, or at least not rising very fast. During this expansion phase, blue chips can double in price.
The problem comes when the economy starts to slow. In a recession or major slowdown, the Dow can lose anywhere from 20 percent to 45 percent. And risky growth stocks can dive more than 75 percent -- as they did during the recent bear market.
The classic way to avoid such horrific losses is to include high-quality income investments in your portfolio. In 2001, for instance, the S&P 500 lost almost 12 percent, while long-term Treasury bonds provided a positive total return of 5 percent or more.
Typical investors (those with horizons of 10 years or longer who are willing to assume a reasonable amount of risk) should keep 35 percent to 60 percent of their money in individual blue-chip growth stocks.
You might also want to put 10 percent of your money in mutual funds that focus on small-cap stocks and a similar amount in funds that hold foreign blue chips. Other equity choices include low-P/E stocks and inflation hedges, such as mining shares and real estate investment trusts.
There's no reason to try to time the market, making big portfolio changes based on guesses about the stock market's next likely move. But value-conscious investing makes a lot of sense. When stocks are cheap, loading up on the shares of high-quality companies is a sensible strategy.
By contrast, when the stock market starts looking overpriced, trimming equity holdings and raising the amount you have in bonds and money funds to more than 25 percent is a smart defensive strategy. As an alternative, preferred shares and tax-free municipals can be very attractive because of their stability and high income.
In any event, assembling the portfolio that's best for you isn't a one-time act. You need a plan for what you want to end up owning and you need to adjust your mix as conditions change.