(MONEY Magazine) – There's only so long you can play a losing game before giving up. In basketball, once coaches see that they can't possibly win, they bench their starters. In boxing, trainers infamously throw in the towel. Even in chess, a smart player may reach a point when he needs to concede defeat, having run out of moves.

If that's how you feel about your portfolio these days, you're not alone. No matter where you turn, the opportunities can seem bleak. Five years of stock gains have been wiped out. Corporate scandals, a prospective war with Iraq and confusing earnings signals linger menacingly. No wonder the No. 1 diversified stock fund this year is the Prudent Bear--a fund that essentially bets on stock prices falling (see "He's No. 1" on page 104). There isn't much joy in Bondville either. A flood of new money rushing into bonds has pushed prices up and yields down. Now, with interest rates already so low, how much new price appreciation can bond investors expect? (Hint: Not much.) And forget about finding a high-yielding place to stash cash. With even 10-year Treasuries paying just 4%, hiding your cash in the backyard, Tony Soprano-style, seems almost prudent.

When faced with these realities, many investors opt for the sidelines rather than charging onto the field. But investing doesn't have to feel like a losing game without options. You can indeed win, but it requires adjusting your strategy--and your expectations--to today's market conditions. Doing nothing may prove the worst alternative. Ask yourself: Is your portfolio properly positioned to capture the best possible long-term returns? Are your "safe" investments really as safe as you think? And if you're desperately holding on to losing positions in the hopes that they'll rebound, are you forgoing the best opportunity in decades to forge lucrative tax savings that could lower your IRS bills now and into the future?

We will help you answer those questions. First we'll examine the real areas of risk for investors today. Next we will identify specific strategies and investments for investors looking for growth, those looking to generate income and those concerned with the best places to stash their cash. Finally, in the accompanying story, "Loss Equals Gain" (page 94), we will outline several sophisticated and relatively simple strategies for maximizing your tax savings. There are always wild cards in our world; we can't say for sure whether we'll see a double-dip recession or how a war with Iraq will affect the global economy. But the following game plan will put you in the best possible position to take advantage of whatever the world throws at you in the coming year.

protecting your portfolio

A few years ago, many of us defined risk as missing out on the next great opportunity--a red-hot tech stock, say, or a sought-after IPO. After so many years of a climbing market, stocks seemed like a sure thing. They weren't, of course, but many of us didn't recognize that until we felt the sharp edge of true risk: losing large amounts of money.

Now it seems we've come full circle. Investors are fleeing stocks and rushing to the perceived safety and security of bonds. As recently as September, $16.1 billion was yanked from stock funds, according to the Investment Company Institute, while $15.9 billion in new money poured into bond funds. One key impetus: The Lehman Brothers aggregate bond index was up 11% in the first nine months of 2002, while the S&P 500 posted a 29% loss.

But consider this. What if buying bonds now is like buying stocks was in the late '90s? What if we're just setting ourselves up for a fall? There's a word for that on Wall Street: whipsawed. It's what happens when you buy a top-performing asset just as it tumbles, then bail out with losses only to reinvest in something that is also about to peak, giving you losses anew. The big risk for investors right now is whether we're learning yesterday's lessons too late and applying them too narrowly. The mania of the late '90s did involve stocks, but it wasn't really about stocks. It was about buying something simply because it had been doing well--and assuming that it would continue to do so. In many ways, that is what's driving the heavy interest in bonds today.

We're not suggesting that you should purge bonds from your portfolio. Diversifying among asset classes is still key to controlling risk in a portfolio, and trying to time the market is a losing bet. But we are urging a candid assessment of the risk/reward profile of everything that you own: What is your upside expectation? What is your downside exposure? How do the different pieces of your portfolio fit together? As you undertake this examination, we offer three observations of our own.

1. Why your "safe" investments may be riskier than you think. A growing chorus of market strategists believes that rushing into bonds is a risky bet these days. Explains Morgan Stanley senior market strategist Byron Wien: "We know it's the wrong time to get into bonds when we're seeing record amounts of money flowing there."

Bond prices fluctuate based on interest rates. The lower rates go, the more valuable existing bonds become. That's what has happened over the past two years as Alan Greenspan and the Federal Reserve drove down the federal funds rate to try to spur the economy. But how much lower, practically, will interest rates fall? At 1.25%, the federal funds rate is the lowest it has been in 41 years. It may go a bit lower, but the degree of positive leverage available to bond investors is greatly diminished.

And what if interest rates should rise instead? Then existing bond prices will plummet. Right now bond investors seem to be betting that the trend toward low rates will continue for a long time. The yield curve, which graphs the rates of the shortest to the longest of Treasuries, is relatively flat now, with the difference between the two being very small these days. But if the economy does indeed kick into gear, that could change rapidly. Sooner or later--as invariably happens during any expansion, even a feeble one--interest rates would rise.

In fact, many of the historical drivers for higher rates have been switched on in the past year: tax cuts, increased government spending on defense, higher oil prices. That does not mean rates will automatically shoot up in the next 12 months, but it does increase the odds that--whether in 2003 or 2004--the direction of interest rates could very well shift. And that would be bad for bond prices.

Of course, bondholders need not sell even if prices do decline. Investors in individual bonds can always hold their bond to maturity, guaranteeing that they get their principal back (provided the issuer remains solvent). But depending on how many years remain until your bond matures, you could face a lengthy period of below-market (and potentially below-inflation) returns.

It can be far worse for bond fund investors. That's because a fund has no maturity date when the return of your principal is guaranteed. Instead, you are at the mercy of your fund manager and how he or she manages an entire portfolio. Back in 1994--the last time interest rates spiked unexpectedly--the average bond fund lost more than 4%, and many of the funds were hammered with double-digit declines. Those that had stretched for yield by buying exotic fixed-income securities were particularly vulnerable to rising rates. The Piper Jaffray Institutional Government Income fund, for instance, dropped a stunning 28% in 1994.

2. Why your "risky" investments may be safer than you think. Now let's talk about stocks. Bears like David Tice argue vehemently that it's still not a good time to invest in stocks. They note that corporate spending has yet to pick up and that the economy could get hurt from a rise in unemployment, an oil price shock or heightened terrorism. Those scenarios are very real. But that doesn't mean the risk/reward profile of equities hasn't become a whole lot more enticing--especially given the perils facing the bond market. As Wells Capital Management chief investment officer James Paulsen notes, "Evidence of great risk is really disguising the seeds of a great investment opportunity."

As we all probably know by now, stocks have historically outperformed every asset class over long periods of time. That's because, unlike bonds and cash, stocks offer the potential to grow along with the economy. If that weren't reason enough to consider stocks, both inflation and interest rates are at historically low levels. On the one hand, that makes it cheaper for businesses to operate, improving their efficiency. But it also makes stocks relatively more appealing for investors--if 10-year Treasuries are paying just 4%, you need only modest earnings growth to have a reasonable chance of better returns.

Finally, corporate earnings are better than newspaper headlines might lead you to believe. According to a mid-October report by Salomon Smith Barney equity strategist Tobias Levkovich, of 191 S&P 500 companies that had reported earnings, there were six positive earnings-per-share announcements for every negative one (that ratio was 5 to 1 in the year's second quarter).

But it's not just quantity that matters. According to Thomas Loeb, co-manager of the Vanguard Asset Allocation fund, the quality of earnings has also been getting better. He argues that corporate cash flows have been improving thanks to inventory reductions and that the trend translates into a favorable earnings outlook for stocks. Loeb has put his money where his mouth is: Earlier this year, he shifted his fund from its usual 65%/35% stock/bond mix to 100% stocks.

Most important, though, is the status of stock valuations. With a bear market now deep into its third year, stocks are no longer priced for perfection. That doesn't mean they are poised to soar immediately, but it does mean that the relative level of risk stock investors are taking today is an order of magnitude smaller than the risk they were taking in early 2000.

3. Why cash is more important than ever. With bonds facing new risks, cash may take on new strategic importance. For growth investors, cash offers a safer way to buffer stock portfolios. It also affords easy liquidity, so you can quickly and cost-effectively take advantage of buying opportunities in the stock market when they present themselves. Growth investors might consider scaling back on bond positions and making larger-than-usual allocations to cash.

For income investors, cash offers solid security. In today's low-yield environment you may feel the need to stretch the risk profile of your investments to generate the income you need. That risk can be balanced by risk-free positions in money-market funds. If interest rates rise, money fund yields rise with them without putting principal at risk. Here rising rates help your return.

For each of us, then, cash offers a flexibility that can prove advantageous in dealing with today's market conditions. That makes cash-management and cash-investment strategies more important than ever. For that reason, the next section of this article--which begins with specific suggestions for growth investors and income investors--ends with a section for everyone on getting the most from your cash position.

for growth investors

It might be worth taking a moment to understand what we mean by growth. We can't expect a repeat of the runaway boom of the late '90s in either the economy or the stock market. That means that annual earnings growth of 20% is, for the most part, a fond memory. Indeed, according to Merrill Lynch chief U.S. strategist Richard Bernstein, "growth investors' expectations will probably come down so much that we'll redefine what is growth." Bernstein and many of his peers expect the stock market to increase roughly 5% to 7% annually over the next five years. That's based on the simple fact that over long periods of time, there are only marginal differences between GDP growth and earnings growth, and GDP is expected to grow by 5% to 6% over the next five years.

The easiest way to capture GDP growth is to own the whole stock market, which is why we recommend the Vanguard Total Stock Market Index (800-851-4999). The fund, which carries a slim 0.2% expense ratio and has a minimum investment of only $3,000, has returned an annualized 8.5% over the past 10 years. That's a little less than the annualized 8.9% return for the Vanguard S&P 500 Index fund over the same period. But the Total Stock Market Index is more diversified and, in volatile times like these, that's an advantage.

We see three other specific areas of opportunity for growth investors. First, there are a handful of beaten-down blue chips that offer palatable risk/reward trade-offs for buy-and-hold portfolios. The key challenge is parsing through the historical blue chips to identify which will retain that status in the years ahead. We assess eight blue-chip candidates on page 43. Among our picks: Coca-Cola (KO), Johnson & Johnson (JNJ) and Microsoft (MSFT).

Second, a sector play: defense stocks, one of the few areas of the economy showing signs of rapid growth as the government ramps up spending. We're enticed by premier missile house Raytheon (RTN), whose earnings are expected to grow 12% a year through 2007, and defense electronics maker L-3 Communications (LLL), which trades for $44 a share, or 16 times estimated 2003 earnings.

Third are dividend-paying stocks. "Take the average dividend yield of 2% today and add, say, 5% growth, and all of a sudden, you're looking at 7% returns," notes Steve Galbraith, Morgan Stanley's chief U.S. strategist. "That's excellent in today's low-return world." Last month we did a full report on what to look for in dividend stocks ("Dividends Are Back in Style"), stressing low payout ratios (dividends per share at less than 50% of earnings per share) and a history of rising dividends. Among our suggestions were Abbott Laboratories (ABT) and Washington Mutual (WM). There are two new names to mention. Gail Bardin of the Hotchkis & Wiley Large Cap Value fund points to Eastman Kodak (EK), a cash cow, which at $34 trades at 12 times estimated 2003 earnings and has a dividend yield of 5.2% and a payout ratio of 38%. She also likes St. Paul Companies (SPC), a property/casualty insurer that has paid a dividend for 131 consecutive years. Currently trading at $33 for 9 times estimated 2003 earnings, it pays a 3.5% dividend and has a payout ratio of 32%.

for income investors

With bond yields so low and bond prices potentially fragile, income investors are in a bind. To raise yield, you need to go further out on the yield curve to longer-maturity issues or go to riskier bonds (corporates, high yield) or dividend-paying stocks. None of the alternatives go down easily for those looking for safe, secure incomes that can stand the test of time. Our suggestion is to barbell your portfolio between the income-producing issues you need and the liquid, short-term cash instruments we'll discuss in the next section. To help you seek income while staying in stocks, the previous section offers some enticing dividend-paying stocks. And if you're comfortable owning a tobacco maker, Philip Morris (MO), with a 6% yield, deserves a look. See also "Stocks and Funds" on page 127 for a selection of options, including real estate investment trust Annaly Mortgage Management (NLY), which pays 15.7%.

Another option: high-yield bonds. Aren't these the riskiest bonds around? Well, usually. After all, the reason high-yield bonds (corporate bonds rated BB or below by the bond-rating agencies) need to offer investors higher yields than those of their safer, investment-grade brethren is because of the above-average risks they carry. And you certainly need to pick your spots in order to avoid firms that can't dig themselves out of their current troubles and thus wind up on the true junk heap.

But investing in carefully chosen high-yield bonds makes more sense in today's economic environment since the bonds tend to perform well in a recovery. While there's a chance that they can suffer from rising interest rates, high-yield bonds typically have higher coupons than those of Treasuries, so their prices aren't as sensitive to hikes. They now yield about 10 percentage points more than the average Treasury. And they offer the potential for capital appreciation if the debt is upgraded by one of the credit rating agencies. As we said, there is always the risk that they'll default, so we suggest investing in a well-run fund like Northeast Investors (800-225-6704), which spreads its investments among many sectors, has a low 0.65% expense ratio and boasts one of the best records over the past 10 years.

Of course, if you're in a high tax bracket you'll want to consider investing in tax-exempt municipal bonds. Because of the tax advantage that municipal bonds offer investors, their yields are typically 80% of Treasury bond yields. Today that ratio is 104%, making municipals an especially attractive option. "In the rush to quality, municipals have been completely overlooked," says Morningstar senior bond fund analyst Eric Jacobson. He likes T. Rowe Price Tax-Free Short Intermediate (800-638-5660), which has an expense ratio of 0.52% vs. the average municipal bond fund's 0.8% fee. The fund has returned 5.97% for the past three years--better than 82% of its peers.

cash strategies

Most investors don't have particularly sophisticated strategies for handling their cash. That's understandable since cash played such a minor role for most of us in recent years (we pumped our assets into stocks as quickly as possible). The usual routine was to just stick some of it in a certificate of deposit and go back to checking on our stocks. But if you choose to use cash as a portfolio counterweight instead of bonds--and as a liquid pool to have available for opportunities--the cash portion of your portfolio may be larger than usual. That makes the impact of smart cash strategies that much more important, even if the yields being offered these days are quite small.

To start, your bill-paying money should probably stay where it is. "When it comes to liquidity needs, convenience is the most important factor," says Peter Crane of iMoneyNet. But with your larger pot of cash--your investment cash--go after the best yields you can find. Financial institutions have made it much easier to move money from one firm to another. So you can keep the bulk of your cash in these higher-yielding accounts and funnel money to your bill-paying account when needed. The competition among banks for assets is producing some very attractive "teaser" rates. Start comparison shopping with our By The Numbers listing on page 213, or visit www.bankrate.com. Once you've spotted the best rate, though, be sure to read the fine print. Some accounts will lock in your money for a fixed period of time, like a CD; others will drop that alluring teaser rate after only three months.

Winning the rate game does require a little elbow grease. But it can pay off. Suppose you had $100,000 parked temporarily in your checking account, which yields, say, 1%. You might consider moving that into a higher-yielding money fund. Here's an even better idea: If in November you moved the $100,000 to ING Direct's Orange savings account, which yielded 2.75%, or Washington Mutual's Platinum Account, which yielded 3%, that $100,000 would have made $1,750 or $2,000 more a year, respectively (before taxes)--and been FDIC-insured. That assumes those rates stay fixed. But even if those rates drop in three months, you'll still have made some extra cash. And at that point, you can easily move on.

One last note: If cash has also been building up in your retirement account, there are appealing options called stable-value funds in many 401(k) plans. Stable-value funds combine bonds, guaranteed investment contracts and cash to provide higher yields than short-term bond funds plus the stability of many funds. The average fund yields 5.5%, well above the average 1.2% rate on money-market funds and the 4.1% average for short-term bond funds. (For more information, see "Funds for Nervous Times" on page 60.) If only these funds were available to all investors, we'd recommend them for everyone.