(MONEY Magazine) – Investors have been nervous ever since early May, when the Federal Reserve first implied that it was on the verge of raising the short-term interest rate it controls. The consensus among economists and investors is that Greenspan & Co. will act as early as the next Fed meeting in late June, marking a turning point.

Wall Street dreads higher interest rates because they can be toxic for stocks and bonds. When rates rise, stocks begin to look less attractive compared with higher-yielding fixed-income investments. Bond investors, meanwhile, are able to get higher yields on new money they put to work but see the value of their current holdings decline (bond prices fall when yields rise). In advance of the Fed's move, 2004's market rally has already stalled--the Dow Jones industrial average dipped below 10,000 in May, falling 8% from its high. Meanwhile, benchmark 10-year Treasury yields have risen to 4.7%.

Robert Hormats, vice chairman of Goldman Sachs International, says that "there's been an overreaction" by the market to the coming rate hike. We agree. It's important to keep in mind that the Fed is able to raise rates now because the economy is growing, unemployment is falling and corporations are turning out phenomenal profit numbers. And inflation, the scourge that the Fed is committed to forestalling, is still low, at just over 2%. The federal funds rate (what banks charge each other for overnight loans, set by the Federal Reserve) is at 1%, a four-decade low.

So why are the markets so skittish? Investors fear a repeat of 1994, when seven rate hikes in a 12-month period brought the Fed funds rate to 6% from 3%. "I think the Fed would like to avoid the mistakes of 1994, and it can because of the low-inflation environment," says Mark Zandi, chief economist at Economy.com. In other words, Greenspan isn't going to slam the brakes on the nascent economic expansion.

What changes should you make to your portfolio in such a climate? We'll look at smart moves you can make with your stock and bond holdings, as well as how so-called alternative investments, such as real estate and commodities, fit into the mix.

Stocks

Contrary to perceptions, stocks historically do well after an initial rate hike (see the middle chart on the facing page), at least in the short term. Why? Perhaps it's because investors tend to overreact in anticipation of rate hikes. Here are three ways to take advantage.

--LOOK FOR YIELD Many dividend-paying stocks have risen sharply in recent weeks as investors have searched for safety. One that still looks attractive: ConocoPhillips (COP). At a recent $73, it trades at just 10 times this year's estimated earnings (vs. ExxonMobil's 15) and yields 2.3%. As a bonus it provides a way to profit from rising energy prices.

--GO-GO GROWTH Growth stocks do well in the early stages of a period of rising rates. "Interest rates are going to go up," says Rick Drake, co-manager of ABN AMRO Growth, a MONEY 100 fund. "But earnings are going up at a faster rate because the economy is picking up, and earnings are what drives the market." Consider pharmaceuticals, a traditional growth industry with demographic trends on its side and a minimal relationship to interest rates. Big drugmakers have been battered by pricing pressures and worries over possible regulation. That's created a bargain: Pfizer (PFE), at $36, or just 17 times expected 2004 earnings, which is well below its historical average. "It's got a very good growth story ahead of it," says Drake.

--CONTRARIAN PLAYS Banks are among the most interest-rate-sensitive sectors. But many banks have shifted from rate-dependent businesses, like lending, to fee-based lines such as asset management, trusts and dealmaking, which typically do well as the economy improves. So we wouldn't be quick to abandon the sector. One bank to consider: Mellon Financial (MEL). Profits have been surging thanks to its trust and money-management units, yet the stock has been hammered on rate fears. At $28, it trades for 15 times projected 2004 earnings. "This stock should do better even as rates go up," argues Mike Holton of T. Rowe Price Financial Services fund.

Bonds

LONG-TERM INVESTORS If you have retirement savings in an intermediate bond fund, and retirement is a long way off, you can probably ride out the current volatility. That's because as you continue to reinvest your dividends, your money buys bonds paying higher yields. Studies show that over time the higher yields on those bonds outweigh any drop in price, giving you a better total return than if rates had stayed flat. "Though your principal value may drop initially, the higher income eventually offsets the loss," says Vanguard research chief Catherine Gordon.

--IMMEDIATE NEEDS Money that you may need to draw on soon should be in a money-market fund. The next safest place is a short-term bond fund--one with an average maturity of three years or less. In the last four rising-rate periods, short-term bonds gained ground while their long-term counterparts tanked. (See the top chart at right.) Vanguard, Fidelity and T. Rowe Price all offer good low-cost fund options.

--MORE TIPS You'll definitely want to lighten up on long-term Treasuries. One great alternative is Treasury Inflation-Protected Securities, or TIPS, which have payouts that keep pace with inflation. But there is a caveat: As fears about rising interest rates have gripped investors, money has poured into TIPS. So don't expect an outsize payoff. Nonetheless, if you're worried about inflation, they're still a fine way to round out your portfolio. You can acquire TIPS directly from the government at treasurydirect.gov or through TIPS funds from Vanguard and Fidelity.

--LOOK ABROAD Many foreign government bonds offer plumper yields at shorter maturities than U.S. bonds. At the same time, foreign bonds can be an excellent counterweight against the falling value of the dollar. "Probably the best bargain today is diversifying away from the dollar, and that is very easy to do in fixed income," says Kathleen Gaffney, co-manager of Loomis Sayles Bond, which has more than 40% of its assets invested abroad. The best way to go about it is through a fund. We recommend one that embraces currency fluctuations to boost returns, such as the Loomis fund or T. Rowe Price International Bond.