The right portfolio for any market
The recent stock slide got you scared? These time-tested strategies ensure you can whether downturns and still benefit from the rebounds.
NEW YORK (MONEY) -- QUESTION: I'm 56 years old and nearly 100% invested in equity mutual funds. I'd like find something to cushion the blow of another stock market decline, but with residential real estate seemingly having run its course and commodities topping out, what alternative do I have? Can you suggest a type of investment that has not recently peaked, and which may offer long-term growth? Real estate in Costa Rica, pipeline limited partnerships...something? - James E. Good, Orlando, Florida
I agree that you need to diversify beyond stock mutual funds, but I think you're going about it the wrong way.
You seem to have the idea that savvy investing consists finding some alternative out there ready to pay outsize gains that's not known to other investors- if only you can get there first!
And, unfortunately, you won't have any trouble finding thousands of obliging advisers eager to help you out, by which I mean they'll sell you an alternative investment that is more likely to fatten their wallet than yours.
Indeed, entire industries that have sprung up to separate investors like you from their money.
In the 1980s the pitch was for various types of limited partnerships (real estate, jojoba beans, windmill farms, etc.). In the '90s it was dot-com stocks and more recently investors have been gaga about foreign currencies and gold.
The problem with this "next best investment" approach is that it's really more like speculating than investing. Sure, maybe betting against the dollar and on precious metals will lead to huge returns, although I'd also note that much of the hoopla that surrounded gold when it hit a 25-year-high of $730 an ounce has faded now that it's trading at less than $590.
I've got a better "alternative" for you - how about a good old-fashioned diversified portfolio of stocks and bonds?
That's right. Good investing doesn't have to be fancy. You don't need exotic limited partnerships or complicated "structured investments" or expensive "fund of funds" hedge funds to create a portfolio that can generate competitive long-term returns while limiting the downside risk in your portfolio.
You can achieve much the same results with a relatively simple mix of stock and bond mutual funds. The key is in getting a stocks/bonds mix that's appropriate for your investment time horizon and risk tolerance - and then diversifying broadly enough so that the various parts of your portfolio don't all move in synch.
On the first score, the stocks/bonds, someone your age should probably be shooting for a portfolio that's roughly 60% to 70% in stocks See how your mix should change depending on how closer you are to retirement.
The stocks will give you a shot at higher long-term gains while bonds will provide a bit of ballast during stock-market downturns. It's also important, however, that your stock position be truly diversified so that too much of your portfolio isn't riding on one sector of the market.
So you want to have large-company stocks, some small-company stocks, growth companies, value shares and, ideally, some international holdings. (See CNNMoney.com's Asset Allocator and the MONEY 65, our selection of best funds.)
As for your bond holdings, your main concern is to protect yourself against rising interest rates. You can do that by keeping most, if not all, of your portfolio in short- to intermediate-term bond funds.
Those maturities typically give you most of the return of long-maturity bonds without getting clobbered as much as long-term bonds when rates trend upward.
You can boost your return potential a bit by devoting a portion of your holdings to high-yield, or junk, bonds, although these bonds have a higher risk of default. So limit them to, say, 10% of your bond portfolio.
Once you've created a diversified portfolio, you should rebalance it every year or so to bring it back to the correct proportions. If, for example, growth stocks have had a fantastic year while value shares have lagged, you can sell take some profits in the growth portion of your portfolio and plow it into value shares.
The same goes for other sectors. Let's say you own some mutual funds that invest in real estate or natural resources. If those funds experience a big run up, restore them to their original percentage of your overall portfolio by selling some shares and pouring the proceeds into parts of your portfolio that have lagged.
By doing this you will automatically be trimming investments that are hot and thus possibly nearing a peak while buying in areas that are less popular and may be poised for larger gains.
The operative words here are "may be." We don't know which sectors will provide the best gains, which is why we hold many different ones and maintain our diversified stance by rebalancing.
I admit that this approach might not be as exciting investing in Costa Rican real estate and it doesn't have the cachet of being in a high-cost hedge fund. But you know what: building a diversified portfolio is easy, can be done cheaply, is relatively simple to monitor and, best of all, it works.
Which is more than I can say for many of the alternatives.