(MONEY Magazine) – You've already read that MONEY's Michael Sivy is forecasting a temporary 15% decline for the stock market sometime in 1997. If you're anything like me, you're probably crossing your fingers hoping that even such a brief interruption doesn't occur. But, judging from the success of his past market calls, I'm not about to bet against him. Moreover, right or wrong, his forecast is an urgently needed reminder that stock prices do fall as well as rise--a basic fact of life that has been easy to forget during this record-breaking 14-year bull market. And if you heed his warning and adjust your fund portfolio to prepare for a rough ride, you'll not only survive 1997 in fine shape, you'll thrive for years to come.

Here's what I mean. In my experience, there are two basic kinds of fund investors: pack rats and portfolio builders. If you're a pack rat, you buy mutual funds the way some people collect matchbooks: Every time you see one you like, you grab it. A couple of years back, I was on a radio talk show when a caller said, "I want to be diversified, so I own Fidelity Growth & Income, Fidelity Equity-Income, Fidelity Equity-Income II, Benham Income & Growth, Dreyfus Growth & Income, T. Rowe Price Growth & Income, Vanguard Equity Income and Scudder Growth & Income." Then he paused for breath and asked: "Is there anything else I should buy?"

"Yes," I told him. "A pair of handcuffs--so you won't be able to buy any more funds that do the same thing as all your others." If I sounded a bit harsh, that's because I wanted this man to realize that by amassing eight funds that all specialize in the same type of security--large income-oriented U.S. stocks--he had built a huge house on a flimsy foundation. When the broad market rises, nearly all growth and income funds will rise; in a shook-up market, almost all of them will fall. Of the five of these funds that were around for the 1990 slump, every single one lost money--at an average clip of 9.2% (vs. 3.1% for the S&P 500). That's not diversification. That's di-worse-ification.

A solid foundation requires three basic building blocks: U.S. stocks, foreign stocks and bonds. By arranging these elements in a way that balances expected returns with your tolerance for risk--and by resolutely sticking with your plan--you reduce your risk while maintaining and possibly improving your returns. If Michael Sivy is right, 1997 will be a turbulent year that will make you very glad you made sure you are a portfolio builder rather than a pack rat.

To see what I mean, let's go back to my radio caller. Recall that in the dark days of 1990, the carbon-copy funds he owned all lost money, at an average rate of 9.2%. But if he had been a portfolio builder instead of a pack rat, his returns would have been much better. That year, while the typical U.S. stock fund lost 6%, cash (as measured by short-term U.S. Treasury bills) returned 7.5%, and intermediate-term government bonds rose 9.5%. If my caller had left only 50% of his money in his average growth and income fund, then put 10% in cash, 20% in bonds and 20% in foreign stocks (which had a terrible 1990, falling 23.5%), he would have cut his losses to a more tolerable 6.6%.

But he made the all too common mistake of concentrating on finding the right fund and neglecting the far more important task of building a proper portfolio. Believe it or not, in the long run it's the behavior of the broad market that does most of the work for even the most brilliant investment pro. Gary Brinson, the brainy money manager who runs Brinson Partners in Chicago, painstakingly analyzed the roles that various factors play in determining investment returns. (The results of his studies were published in 1986 and 1991 in the Financial Analysts Journal.) Brinson and his co-authors found that 91.5% of investment results can be explained purely by your asset mix--the proportions of your portfolio you dedicate to broad investment categories like stocks, bonds and cash. Other factors that many investors view as crucial--such as the choice of specific securities and the timing of purchases and sales--accounted for only 8.5% of the results.

What that means in the real world may surprise you: Two investors who choose the same asset mix--putting, say, 60% of their money into stocks and 40% into bonds--will tend to end up with pretty much the same results in the long run, regardless of the particular bonds and stocks they choose. Meanwhile, an investor with 80% in stocks and 20% in bonds will fare very differently from 60-40 investors.

I can't put it any more plainly than this: Diversification is destiny. Your return will be determined far more by which category of fund you buy than by which fund you select within the category. So why work yourself up into a lather trying to pick the funds that will have the best performance, when less than a tenth of your long-term return is dependent on the results of those decisions?

That's not to say your choice of funds does not matter at all. It does. But before you dedicate any energy to selecting individual funds, you should step back and look at your overall fund portfolio. There's no point asking, "Should I buy this fund?" unless you have first asked yourself, "Do I have too much money, or too little, in U.S. stocks? Am I forgetting to use all three building blocks?"

So let's look at the key building blocks, one by one, and see how you can use them to make sure your fund portfolio is soundly constructed.

WHY YOU SHOULD NEVER BAN THE BOND

Bonds seem to have gotten a bad name with individual investors lately--but it's a bum rap. Back in 1993, investors crammed $114 billion into fixed-income funds, nearly as much as they packed into equity funds ($130 billion). Many of those bond fund investors apparently believed they were merely buying higher-yielding versions of bank accounts. In 1994 they found out the difference between guaranteed bank yields and gyrating bond returns. As interest rates rose throughout the year, bond prices fell, and the average U.S. taxable bond fund lost 3.3%. Suddenly, the flood of cash dried up: In 1995 and 1996, investors have added a relatively meager $4.6 billion to bond funds while pouring an astonishing $307 billion into stock funds.

But ignoring bonds is a big mistake, for three big reasons. First, bonds tend to zig when stocks sag. Since 1926, there have been eight calendar years in which U.S. stocks fell at least 10%. (The average decline: 22.1%.) But in only one of those years did intermediate government bonds lose money--in 1931, when they fell 2.3%. By contrast, stocks tumbled 43.3% that year.

The second reason you want to own bonds is that, in the long run, they earn their returns more predictably than stocks do. Let's say you buy a 10-year Treasury note at its par value of $10,000, with a 6 1/2% interest coupon. (That's roughly what you could recently get in the bond market.) Simply hang on and you're certain to get your $10,000 back in 2007--and every six months from now till then this bond will pay you $325, for a total of $6,500. Along the way, you'll be able to reinvest the interest. Assuming an average rate of 6 1/2% when you reinvest, you'll earn another $2,458 as your interest compounds. I call this interest-on-interest amoeba money, because it multiplies by itself.

Well-managed bond funds enjoy the same predictability--over the long term. True, bond funds never mature, so you can't simply hold on and be sure of getting your full principal back. Bond fund shares gain or lose value as interest rates rise and fall. But good bond fund managers concentrate on keeping net asset value as stable as possible and avoid using risky strategies to pump up current yield. At these funds, price changes have tended to cancel each other out over periods of 10 years or more, leaving you with a total return roughly equal to the interest rate the fund was paying at the time you invested.

The third reason you want to own bonds is that they may actually return more, not less, than stocks in coming years. Here's why. Stock returns are driven by three factors: dividend yield, growth in earnings, and changes in market valuation. The current dividend yield on stocks (the past 12 months of dividends per share, divided by the stock price) is 2%. We can't be certain how fast corporate earnings will grow, although the long-term average is a bit more than 6%. Add that to the dividend yield, and you get a projected average annual return on stocks of about 8%. Market valuation--the price investors are willing to pay for each dollar of earnings--is pure guesswork. All we know for sure is that in 1996, investors were paying as much as $19.30 for each $1 of the previous 12 months' earnings (in other words, the market's trailing price/earnings ratio was 19.3), vs. the long-term average trailing P/E multiple of 14.9.

If that already lofty earnings multiple climbs even higher, stocks could return more than 8% annually during the next few years; if it stays the same, stocks will earn about 8%; and if it sinks, stocks will earn less. For example, if the earnings multiple reverts to its long-term average of less than 15, stocks will return somewhere between 6% and 7% annually for the next decade. If it dips even lower (as it often has in the past), stocks could return even less. Thus it's not just possible, but quite likely, that stocks will do no better than bonds during the next 10 years. The main difference between them is that you can get a near-certain return of 6% to 7% on bonds. With stocks, you might do better than that and you might do worse, but you can't be sure which.

In short, you should always own a sizable slug of stocks, no matter what your risk tolerance, because they offer the hope of superior returns--witness the S&P 500's 45% total return since Jan. 1, 1995. But you should also always own some bonds, because they offer the virtue of more predictable returns.

Ian MacKinnon, who supervises fixed-income investments at $232 billion fund giant Vanguard, typically keeps 80% of his own personal portfolio in stocks and 20% in bonds. But recently, MacKinnon, 48, cut back to a 65-35 stock-to-bond mix. He thinks that level is a pretty good one for a moderate-risk investor, and I agree. If you think you crave higher risk, an 80-20 stock/bond mix may still be your speed. If you are on the conservative side--perhaps because you are nearing retirement or are already in it--fifty-fifty or even 40% stocks, 60% bonds may be right.

When investing in bonds, it's important to keep taxes in mind. Because bond funds throw off a lot of taxable income, in my opinion you want to hold them in a tax-sheltered account, such as an IRA, if possible. Or you can invest in municipal bond funds, which generate tax-free income and normally produce higher after-tax yields for taxpayers in all but the lowest federal tax bracket.

In any case, there's no better place to do one-stop shopping for bond funds than MacKinnon's home base, Vanguard. Why? First of all, Vanguard's rock-bottom costs give its funds a built-in advantage. The typical junk bond fund, for instance, charges 1.38% of assets in annual expenses, and the average Treasury bond fund charges 0.82%; Vanguard's junk fund charges 0.34% and its intermediate Treasury fund an even cheaper 0.28%.

But Vanguard's bond funds typically outperform their peers by considerably more than their expense advantage alone. That's because MacKinnon and other members of Vanguard's bond brain trust, such as Christopher Ryon, 40, and Robert F. Auwaerter, 41 (the trio are pictured on page 88), manage for total return, not maximum yield--which, over time, gives their funds more stable and predictable results than their rivals. Further, Vanguard's managers have a good record of cautiously shortening maturities when they think interest rates may rise and lengthening them moderately when they think rates will fall.

In a tax-sheltered retirement account, you might want to combine an investment-grade fund like $448 million Vanguard Intermediate-Term Bond Index (or slightly higher-yielding $7.4 billion Vanguard GNMA) with a junk bond fund like $3.5 billion Vanguard High-Yield Corporate. MacKinnon feels that junk bonds now offer more than enough yield to compensate for their higher risk. (See the table on page 86 for key performance figures and other data on all the funds mentioned in this story.)

Or you can take bond diversification one step further with funds that hold debt securities of all kinds from around the globe in a kind of fixed-income goulash. Three such funds I like for their moderate expenses, eclectic diversification and astute management are $285 million Harbor Bond, $611 million Janus Flexible Income and $500 million Loomis Sayles Bond.

In your regular taxable accounts, a good blend would be $1.3 billion Vanguard Intermediate-Term U.S. Treasury, which is exempt from most state income taxes; and $6.1 billion Vanguard Municipal Bond Intermediate-Term (a so-called national muni fund that invests in bonds from around the nation and is exempt from federal and some state income tax).

HOW FOREIGN FUNDS FIT IN

According to a recent survey by the Scudder fund group, 71% of all fund investors have no money at all in foreign or global funds, presumably because many dismiss international markets as too risky.

But, along with bonds and U.S. stocks, you need foreign stocks as the final building block of a sturdy portfolio. Yes, foreign stocks do often move in the same direction as ours--they've fallen in four of the five most recent down years for U.S. stocks. Typically, though, their price swings are either much bigger or much smaller than those in the U.S. That's what statisticians call low covariance. It tends to smooth out the bumps in your returns, and it's what makes diversification work.

You'll find recommendations of 12 foreign funds in "Earn 20% Investing Abroad" on page 98. One other name to consider: $1.7 billion Acorn International. This fund has four great strengths: low expenses, broad geographic diversification, experienced managers and price-conscious stock picking. Co-manager Leah Zell, 47 (pictured on page 84), who runs the fund with Acorn veteran Ralph Wanger, 62, describes Acorn's approach this way: "Have you ever heard the joke about the man who lost his keys two blocks away but is looking under a lamppost instead because 'the light is better here'? Well, while everyone else is looking around under the lampposts, we're combing the streets with our own flashlights, trying to find great companies they've missed."

WITH DOMESTIC FUNDS, LESS IS MORE

I've saved the third building block--U.S. stock funds--for last, since most of you already own at least one of them. You may, in fact, own too many. That's because when it comes to U.S. stock funds, financial planners and other pundits often recommend spreading your bets across small stocks and large, as well as across growth stocks with rapidly rising earnings and value stocks selling for less than their true worth. Thus they suggest you put roughly 25% of your U.S. stock assets in each of the following groups: small-cap growth, small-cap value, large-cap growth, large-cap value.

But I think this "four basic food groups" approach is a recipe for indigestion. For example, small growth stocks--as measured by the Russell 2000 growth index--account for only about 5% of the total capitalization of the U.S. market. So, if you put 25% of your U.S. stock fund assets in these highly volatile companies, you will be placing a bet five times bigger than the stock market itself has decided is appropriate.

That's not exactly an effective way to minimize risk--especially at a time when small growth stocks are trading at valuations high enough to induce oxygen deprivation. (The Russell small growth index is trading at 35.3 times the past 12 months' earnings, vs. 19.3 for the big-stock S&P 500.)

If the overall stock market gets bruised, small stocks are likely to take a bloody battering: Going back to 1926, investors in large U.S. stocks have lost money in 20 calendar years. (The last negative year was 1990, when big stocks fell 3%.) Their average loss in those 20 slumps was 12.3%. Small stocks, meanwhile, dropped in almost the same number of years--21--but they lost a much worse average of 19.3%.

What about the argument that small stocks outperform big ones in the long run? As I wrote in this past February's issue, the evidence for this theory is surprisingly weak. But if you nevertheless want to gamble on small stocks, I recommend hedging your bet by picking a fund that is not purely small cap. A fund that blends little stocks with big ones should give you less risk than a straight small-cap fund and the chance to capture a portion of any superior returns that small stocks may produce.

Here a sound choice is Lindner Growth. This $1.5 billion fund, founded in 1973, does not shine in bull markets; over the past 10 mostly bullish years, it has annually lagged the S&P 500 by about two percentage points. But it tends to be boffo in bear markets. In 1987, for instance, it was up 8.8%, vs. 5.3% for the S&P index. A team led by Eric Ryback (pictured on page 83) lards this fund with a mix of 50% small stocks, 25% large stocks and 25% midcap ones; the average market value of the 200 stocks in its portfolio is just $610 million, vs. $8.1 billion for the typical growth fund.

Lindner steadfastly refuses to buy high-flying stocks. "We want companies that have fallen on hard times in their business and dropped out of favor on Wall Street," says Ryback, 44. One example: $8.2 billion electric utility El Paso Electric, which is emerging from bankruptcy and trading for less than nine times Ryback's estimate of this year's earnings. Ryback expects the company to start paying a dividend out of its $2.50 per share cash flow next year, helping to lift the share price.

Because many of Lindner's stocks are small and nearly all are cheap, says Ryback, "The portfolio dissociates itself from the market." Indeed, less than half of Lindner's returns can be attributed to the movements of the S&P 500. That relationship may get even more remote--for better or worse--in 1997: Ryback says he expects to increase his cash position from its current 4% to 25% in the next few months. "A setback in the market is long overdue," he says, "and we want to preserve the gains we've made."

By combining an idiosyncratic fund like this with a basic core U.S. stock fund, you pick up some diversification without taking on too much risk. Lindner Growth is a nice complement to such dependable big-company staples as these: $3.2 billion Davis New York Venture, which value maven Shelby Davis has led to a market-beating 17.2% average annual return in the past decade; $2.1 billion Dodge & Cox Stock, whose management team has produced a 14.9% annualized 10-year return; $4.3 billion Fidelity Fund, now led by veteran Beth Terrana, which has just about matched the market in the past 10 years but at 20% less risk; $5.4 billion Neuberger & Berman Guardian, where experienced skippers Kent Simons and Lawrence Marx have also produced market-matching returns while lowering risk over the past decade; $2.3 billion T. Rowe Price Growth & Income, whose manager Stephen Boesel has kept risk down while nearly equaling the market in the past 10 years; or $28.9 billion Vanguard Index 500, whose autopilot, Gus Sauter, relies heavily on computer models to mimic the returns of the S&P 500 for a satisfying average annual gain of 14.7% since 1987.

Now that we've worked our way through all three building blocks, you should have a simple, sturdy structure of funds. Don't clutter it up. Mutual funds are supposed to simplify your financial life, not complicate it. Remember that you want to be a portfolio builder, not a pack rat. And, whatever you do, don't rearrange your building blocks every time the market bounces up or down. Once you build a fund structure, stick with it. That's the best way to use funds to prosper in 1997--and for years to come.