NEW YORK (MONEY Magazine) -
What should you worry about? The frying pan? The fire? Both?
Today's aimless stock market is bad enough, but in 2006 you have some potential unpleasantness that could hit your portfolio from opposite directions.
One dreaded scenario is years of higher inflation, perhaps augured by the recent spike in energy prices. The other specter is a recession -- a shrinking economy brought on by too-high interest rates that dampen economic activity and pop the housing bubble.
So how do you prepare for inflation and recession? You start by understanding that neither you nor anyone else can predict with any certainty which hazard, if either, will come to pass.
One of investors' biggest mistakes, says Dreyfus chief economist Richard Hoey, is responding to a plausible prediction of the future by investing as if that scenario were a sure thing.
"You need a strategy that will have a low probability of giving you a disastrous outcome if you're wrong," says Hoey. Here's how to insulate yourself from shock, without missing a stock market rally if the economic clouds part.
Move No. 1: Think bonds Certain yield-boosting investments in the bond market could turn ugly if conditions get unpleasant in 2006. High- yield debt (junk bonds) usually gets whacked in a recession owing to its increased risk of default.
Long-term bonds, meanwhile, will see their value eaten away by inflation and rising rates.
Adopt a safe all-weather bond strategy that starts with short- and intermediate-term debt. Add to that mix a 25 percent allocation to foreign debt, such as the MONEY 50's American Century International Bond fund (BEGBX), and about half that amount to Treasury Inflation- Protected Securities.
You can buy TIPS at treasurydirect .gov. Fund investors can buy the Vanguard Inflation- Protected Securities fund (VIPSX), another selection from the MONEY 50.
Move No. 2: Easy on the hard stuff Hard assets, including real estate, oil and gold, are classic inflation hedges.
But they've all run up in recent years, depleting their power as a value preserver. And if they dominate your portfolio, you'll get clobbered in a recession.
So put no more than 10 percent of your portfolio in REIT funds, and no more than 10 percent in commodities and natural resources.
By no means should you invest directly in commodities. Start with the T. Rowe Price New Era fund (PRNEX) or the less energy-intensive Pimco CommodityRealReturn Strategy fund (PCRAX).
Move No. 3: Be nimble with cash Stay short with your cash savings for at least the first half of 2006. As the Federal Reserve continues to push up interest rates, short-term rates could pass 4.5 percent, up from just 2.25 percent in early 2005.
Money-market funds, which react quickly to rate hikes, will keep pace with the rise. They'll also keep your cash accessible. So should rates stall or even drop next autumn, you can roll into a longer-term CD to lock in high yields, suggests Greg McBride of Bankrate.com. Search for good savings rates here.
Move No. 4: Look for stocks and funds for all seasons Some market segments do well in a period of high inflation; others hold up in a recession. You want some of both in 2006. Here are sectors that typically do well in these conditions, plus leading stocks in those groups.
Dominant tech They can maintain profits since customers have few alternatives. Consider: Cisco (Research)
Food Suppliers have flexibility to raise prices quickly. Consider: Sysco (Research)
Energy Can these guys raise prices in a hurry? You already know the answer. Consider: ExxonMobil (Research)
Large cap growth funds Consider: Harbor Capital Appreciation (HCAIX)
Consumer staples In hard times, people still do the laundry and brush their teeth. Consider: Procter & Gamble (Research)
Utilities Steady demand for power and steady dividend payouts buttress these stocks. Consider: Southern Co. (Research)
Dividend value funds Consider: T. Rowe Price Equity Income (PRFDX)
Also: See Michael Sivy's 7 blue chips for 2006.
Money 101: Investing in funds
More moves for 2006...