Building a Portfolio for All Seasons
The right investment mix will propel you along the road to financial success.

During the three calendar years from 2000 to 2002, the stock market pitched downward, and perhaps your investment portfolio went along for the ride. For the next four years, from the end of the growly bear market through 2006, the market reversed direction. Given the market's ups and downs this year, some investors are wondering what the rest of 2007 will bring.

"Markets go up and down," quips Rozanna Patane, a financial advisor based in York Harbor, Maine. "We can't predict what the coming months will bring, nor should we be overly concerned. If we're long-term investors, we build a portfolio that will see us through up times, down times, and flat times."

The key to building such a portfolio starts with some introspection. "First, you need to have a long-term plan—you need to know why you're investing and what you're investing for," Patane says. "Second, you need to select diversified investments that together provide an appropriate level of risk and potential return."

Know where you're headed
Are you saving for a new car? A new home? Your child's education? Of course, you'll eventually need to build a nest egg to carry you through retirement. How do your future needs match up with the amount you're currently saving? These are the kinds of questions you should ask yourself while constructing your optimal portfolio.

Perhaps the most important question of all—but one that can only be answered by first tackling the others—is to know your time horizon. In other words, when might you need to first withdraw from your savings, and how much would you need at that point?

"When I help people design portfolios, I first ask them to identify short-term and long-term goals," says Michael Pace, a registered investment advisor in Seattle. "We try to identify future capital expenditures—a home purchase, college tuition, a new car. For most people, the biggest expenditure by far will be getting through the retirement years. The need for cash today, tomorrow, or 20 years from now is what should determine the investments you plug into a portfolio."

Create your target mix
While the world of investments offers countless opportunities—and dangers—all investments qualify as either equity (stocks and, to a lesser extent, real estate and gold), or fixed income, which represents money you've loaned in return for interest (bonds, CDs, and money market funds).

Historically, stocks have provided much greater returns than fixed income investments, but they also have been considerably more volatile.

Consider the following data* from Morningstar: Since 1926, large-company stocks have clocked an impressive average annual return of 10.4%, assuming reinvested dividends. Conversely, the average annual return of long-term government bonds has been only 5.5%. But the bond market rarely goes into negative territory, and long-term government bonds have never dipped more than 9.18% in a single year.

The stock market, in contrast, loses money in almost one of every three years, and in the recent three-year bear market, lost about a third of its value. Some stocks, such as shares of technology companies during the dot-com bust in early 2000, can take an even more dramatic hit.

A well-diversified portfolio will have both stocks and bonds. Investment professionals say that these two kinds of investments have "negative correlation"—meaning that stocks and bonds tend to move differently in relation to the other and do not rise and fall together. In a year when your stocks are shooting high, your bonds may lag. The next year, stocks may fall, but bonds may rise. (In fact, when large company stocks declined 22.10% in 2002, long-term government bonds gained 17.84%.**) Having both stocks and bonds in a portfolio usually helps to smooth out your returns.

But what is the best ratio of stocks to bonds to cash? Is it 70% stocks, 25% bonds, and 5% cash? Or is it 50% stocks, 35% bonds, and 15% cash, or perhaps some other combination? That's where your time horizon becomes an essential factor.

"Generally, any money that we might need to tap within the next four years, we want to keep in cash or fixed-income investments," Pace says. "Money that won't be needed for five or more years, such as money for retirement, if I'm working with 30- or 40-something people, we want primarily in equity, such as stocks." A typical 35-year-old saving for retirement, for example, might allocate about 80% to stocks, Pace says. A typical 45-year-old might want closer to 70%.

Pace explains that money needed within the next four years should be invested so there is minimal risk to the principal. Beyond four years, taking the added risk of the stock market is usually a fair trade-off for the expected greater return, he believes. "But people have very different risk preferences," adds Pace. "You need to ask yourself how much you're willing to see your portfolio drop in any one- or two-year period." As with all your investments, you also must ask yourself whether they are consistent with your objectives, risk tolerance, and financial situation.

Fine-tune your portfolio
Just as stocks and bonds tend to have a negative correlation, different kinds of stocks and different kinds of bonds similarly have limited correlation. That's especially true on the stock side of the portfolio. Savvy investors typically will make sure to have both domestic and international stocks, stocks in both large companies and small companies, and both value and growth stocks.

Growth stocks are usually defined as shares in fast-growing companies in—you guessed it—fast-growing industries. Value stocks are those that people believe are worth more than the market price based on some fundamental value, such as a price to book ratio.

Different "asset classes" perform differently at different times. That's the very heart of diversification, a strategy that helps you manage risk but does not completely protect you from possible losses.

After you have all the broad asset classes covered, you might consider branching out into narrower (but not too narrow) kinds of investments. Possibilities would include high-yield bonds, small international company stocks, commodities, and certain industry sectors of the economy, especially those that tend historically to have limited correlation to the market at large, such as real estate and energy.

Putting a plan into practice
It is very hard to achieve the kind of solid diversification, as described above, by investing in individual securities. "Unless you have a ton of money, it is virtually impossible to own a sufficient number of stocks so as to be diversified across the board...domestic and international, companies of different sizes, and different industries. Owning mutual funds or exchange-traded funds makes achieving good diversification much easier," Pace says.

Exchange-traded funds (ETFs) are akin to index mutual funds, but they trade like stocks. Generally, you will pay a commission to buy an ETF, so mutual funds generally will make more sense if you are contributing regular, small amounts to your account.

One caveat: Pay little attention to which asset class happens to have performed especially well in recent months. The vast majority of investors make the mistake of pouring money into "hot" sectors, then selling off when those sectors cool. They are continually buying high and selling low. That is exactly the opposite of what you should do, Patane says.

"Pick an allocation and stick with it," Patane suggests. "Don't forget your goals. Don't panic and sell when the market drops." She also cautions against market timing. "The best time to invest is always right now," she says. "Lots of people sit on the sidelines, keeping their money in cash, waiting for the right moment to buy. That's a mistake. You stand to lose more than you stand to gain."

If 2007 turns out to be a gangbuster year on Wall Street, a portfolio that started the year with 60% in stocks and 40% in bonds might wind up the year with 70% in stocks and 30% in bonds, Patane says. When things get out of whack, you'll need to rebalance and get back to your original allocation. This means selling stocks and buying bonds. Or you could avoid selling your stock holdings by directing new purchases into bonds.

Many financial experts recommend that you look over your portfolio every 12 to 18 months. If the urge strikes you to shuffle things around much more often than that, resist, say the experts. "Buy-and-hold investors tend to be the most successful investors over the long run," Patane says.