(MONEY Magazine) – PAUL PLASTERER WORKS FOR A HIGH-END sporting goods company in Chicago, and if you ask him about his job, you'll quickly realize that he's a pretty business-savvy guy. He doesn't, however, have any illusions that he's a market whiz. His strategy: "When I see that one of my funds isn't doing well, I cut back on it and move that money over to the fund that's putting up stronger numbers."

Uh-oh. Paul might not see himself this way, but he's a performance chaser, and these are heady--and dangerous--days for folks like him. The Dow and the S&P 500 are starting to look reasonably good, but the big action is in, well, just about everything else, and the more exotic the better: emerging markets funds, portfolios hitched to soaring commodity prices, and the stocks of small, risky companies. Look through your 401(k) plan choices and you'll likely find funds in these areas that have doubled in the past three years.

What's all too easy to forget is how far, and how fast, these kinds of investments can fall. The average emerging markets fund, for example, lost 26% in 1998, rebounded and then fell another 30% in 2000, according to Morningstar.

This is where you might expect us to poke a little fun at Paul and then tell you to run from the craps table before you lose big. Not exactly. Paul's a smart guy who's just being human: We're all instinctively drawn to winners. More to the point, emerging markets, small-caps, commodities, even last year's hot ticket--real estate--can play a role in a sensibly diversified portfolio. So unless you have perfect market-timing instincts (hint: you don't), the challenge for you isn't deciding whether to rush into or cash out of these areas. Rather, it's figuring out how much of your money belongs in these kinds of investments over the next decade, and resolving to stick to that plan. Read on to see what you can expect from the market's hottest spots, and how they might fit into your portfolio. First, here are four rules you have to remember at a time when risk is back in vogue.

• LEARN TO LOVE LOSING When you buy, say, a small-cap growth fund, there's a bad thing and a worse thing that can happen. The bad thing is that the fund might have a lousy stretch. (Count on this one.) The worse thing is that you may be so shaken that you sell just in time to come out a loser and miss the rebound. So remind yourself that you bought the fund not just to capture high returns but to have something that doesn't move in lockstep with your blue-chip stocks. That means living with bad years. "You should always have a dog or two in your portfolio so you know you are diversified," quips financial planner Chris Cordaro of Regent Atlantic Capital in Chatham, N.J.

• DON'T MAKE THE SAME BET TWICE During the late-'90s bull market, notes Morningstar director of fund research Russel Kinnel, "if you were chasing performance, you ended up buying different flavors of tech." In other words, if you owned both a technology fund and a large-cap growth fund with big stakes in Dell and Cisco, you were doubling down on the New Economy whether you knew it or not. "Now performance chasers are buying different flavors of commodities," says Kinnel. Example: Latin American economies have been stoked by the demand for those nations' commodities. And China's and India's booms helped create the feverish demand in the first place. So there's a good chance that when emerging markets funds and natural-resources funds start to lag, they'll do it together.

• DON'T BE AFRAID OF SELLING TOO EARLY When you own a fund that's been putting up double-digit returns for years, it's tempting to let it ride and hope to get out when the momentum is gone but before the crash. That's tough to pull off. One reason the markets look so lopsided now is that hedge funds and other institutional investors have been doing a lot of performance chasing too. And they're a whole lot quicker than Paul or you. "As soon as this strategy stops working, that money will come right out," says Prudential Equity Group small-cap analyst Steven DeSanctis. Don't count on beating the pros to the exits.

• INSTEAD, BUY THE STUFF THAT STINKS Strong returns can throw off your asset allocation, as your best investments take up a bigger chunk of your portfolio. So take a look at what you have to make sure you haven't become overexposed to risky plays, and then rebalance if necessary. Take some of your hot-fund profits and put them into cash, bonds or lagging areas such as blue-chip U.S. growth stocks or funds. (Not that those can't go down. They're cheap now in part because they weren't in 2000.) For specific investments, see Fund Watch on page 68, and Sivy on Stocks on page 72. You'll be locking in some profits and, with luck, buying shares at what will later prove to have been low prices.

Now for that closer look at what's driving the market's most explosive sectors. Overlap alert: You may not need any of these types of funds, especially if you invest in diversified index or target-retirement funds. If so, you already own most or all of these asset classes. In general, allocating 15% to 20% of your portfolio to small-caps can make sense if you are an aggressive investor; emerging markets, natural-resources and precious-metals funds are bolder plays. Think single-digit allocations. See the MONEY 65 table on page 70 for our fund picks in these areas. Check for overlap by looking at your funds' shareholder reports, which list holdings.

• Small Companies

VALUE STOCKS

Risk Level Low Sky-high

GROWTH STOCKS

Risk Level Low Sky-high

• IN RECENT YEARS, small-company shares had three big things in their favor: low interest rates, strong economic growth and relatively low prices. But the recovery is long in the tooth, and small-caps are no longer cheap. Lehman Brothers analyst James Furey notes that the companies in the small-cap Russell 2000 index were selling for 1.2 times sales at the end of March, their highest quarter-end price since 1998. Why are they so popular? John Hussman of the Hussman Funds senses an element of desperation here: Blue chips haven't fallen enough to look like incredible bargains, but investors remain hungry for big returns, which small companies can provide if they keep posting huge earnings growth. "The investor is taking an interest in things that are working right now," he says.

Eventually that kind of thinking ends--usually when the economy sputters. "You don't want to be around small-caps in a recession," says Furey. Prudential's DeSanctis notes that when small-caps stop beating the bigs, they lose an average of almost 22% in nine months. Even some of the fund managers who specialize in small-caps expect them to cool. "It's been a special moment for small-caps," says manager Chuck Royce of the Royce Funds, which recently closed two portfolios to new investors to keep assets manageable. "This is the end of that run, not the beginning."

! OVERLAP ALERT Plenty of "large-cap" and "midcap" funds also invest a significant chunk of their assets in smaller companies.

• Emerging Markets

Risk Level Low Sky-high

• EMERGING MARKETS funds have been rallying since 2003, and they are starting to show signs of faddishness, with money managers opening funds to take advantage of the hottest markets or investment themes. Templeton, for instance, is opening a BRIC fund. (That stands for Brazil, Russia, India and China, natch.) Of course, the trends driving these markets--most important, the emergence of China and India as major players in the global economic system--aren't going away soon.

But it's still easy to imagine events that could knock shares down fast. For starters: another round of nuclear brinkmanship between India and Pakistan, or a U.S. face-off with Venezuela. "I tell my clients, emerging markets are going to be the highest-returning area in your portfolio," says financial planner Cordaro. "But I know that within six years one of those countries is going to do something stupid and drag everyone down, and we'll be down 20%. That's when we buy more." If you don't have the stomach or the time horizon for that kind of thing, don't go there. Or consider getting in less directly. "Start with a diversified foreign fund with some emerging markets exposure, and that's probably enough," says Morningstar's Kinnel. MONEY 65 pick T. Rowe Price International Discovery recently had about 9% of its assets in Indian stocks.

! OVERLAP ALERT Many diversified foreign funds maintain a sizable stake in emerging markets stocks.

• Natural Resources

Risk Level Low Sky-high

• IN 1981 OIL PRICES HIT $39 a barrel, from around $15 in 1979. Armand Hammer, then chairman of Occidental Petroleum, was warning that oil could hit $100. In fact, prices tumbled to just $10 by 1986. This is a useful bit of history to keep in mind as oil dances around $75 a barrel. Big-money investors love commodities right now, and it's hard to say how much of this is driven by a long-term interest in better diversification and how much is due to pure speculation. Worsening tensions with Iran or the political troubles inside Nigeria could push prices still higher, but by the same token an improvement in the political situation, or a faster-than-expected global slowdown, could knock them back down hard.

Most natural-resources funds aren't directly exposed to the ups and downs of oil prices. Instead, they buy stocks in energy-related businesses and may diversify into other sectors, including natural gas and metals. That means they can perform differently from oil. Nevertheless, they can still lose 30% or more in a year. The best rationale for buying these funds is that they're decent diversifiers: The same rising energy prices that can pump up their returns may be pummeling the share prices of companies that you hold elsewhere in your portfolio.

! OVERLAP ALERT Emerging markets and natural-resources funds are driven by some of the same economic forces. Blue-chip and index funds own energy stocks.

• Precious Metals

Risk Level Low Sky-high

• JUST LIKE OIL, gold has been on a frantic tear lately. It recently hit $639 an ounce, up from $250 in 1999. And, again like oil, investors can expect huge swings of fortune. If you bought an ounce of gold in the early '80s, you're down about $200 before inflation. As an investment, gold is an oddity. It's not terribly useful: Most of it goes into making jewelry, about half of which itself may be purchased as an investment. Gold tends to do best when people lose faith in other assets, including paper money. There's a lot of that angst going around. Joe Sterling, co-manager of American Century Global Gold fund, says scary world politics, big U.S. deficits and rising inflation fears are in the metal's favor.

But even if you think you can handle gold's volatility, think twice about buying a gold fund if you also own other natural-resources stocks. Rising energy prices have not only stoked inflation fears. They've also pumped a lot of cash into oil-producing countries, and it's possible that some of that money is being parked in gold for now, says Mark Johnson of the USAA Precious Metals & Minerals fund. Gold also seems to be a favorite of the same investors who have fallen in love with other commodities. When this bull market in real assets dies--whether it's in a few months or a few years--you may well be glad you hung on to those boring old Microsoft shares.

! OVERLAP ALERT Gold and "black gold" (oil) are moving up for a lot of the same reasons.

The tally

KEEP ON ROLLING?

Blue chips aren't back to even...

Dow 30

S&P 500

Price appreciation per $100 invested

NOTE: Monthly data as of April 17.

SOURCE: Thomson/Baseline.

...while riskier stuff is on a hot streak of late.

THREE-YEAR TOTAL FUND RETURNS

Large-caps 61%

Small-caps 108%

Natural resources 160%

Precious metals 161%

Emerging markets 202%

NOTE: Data as of March 31.

SOURCE: Morningstar.

But hot streaks can go cold.

• GOLD

PER OUNCE, '80 TO '99

$850 $255

• EMERGING MARKETS

JULY '97 TO AUG. '98

-57%

• SMALL-CAPS VS. LARGE-CAPS

MARCH '94 TO FEB. '99

-126% points

• OIL

PER BARREL, '81 TO '86

$39 $10

SOURCES: Bloomberg, Energy Information Administration, Morningstar, Thomson/Baseline.

invest

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The hardest thing to do in investing by Penelope Wang 68

Sivy on Stocks by Michael Sivy 72