By Lauren Young
October 16, 2002

ROBERT BURKETT HAD HAD ENOUGH. He'd watched thousands of dollars disappear from his 401(k) account over the past couple of years. As soon as the Dow Jones Industrial Average fell below 9000 in July, the Tulsa, Okla., engineer, 43, dumped all the stock funds from his retirement portfolio and moved the remaining proceeds into a Treasury fund.

"I got tired of watching everything disappear," Burkett explains. "I wish I had taken the money out sooner and stuck it in CDs." Doesn't he care that most certificates of deposit are yielding less than 2%? Nope. "At least I wouldn't have lost money," he explains.

With the Standard & Poor's 500 index off almost 20% and the Nasdaq down a painful 30% this year alone, many people are looking for capital preservation first, growth second. Understandably, the market's downswings over the past two and a half years have made many people queasy. But is there a saner way for nervous investors to react than by stowing everything in a low-paying savings account? That's what SmartMoney set out to discover.

The good news? It is possible to construct a diversified portfolio that will continue to grow over time with extremely little volatility. Of course, striking the right risk/reward payoff is an important consideration. So we looked for investments with limited downside and a reasonable upside of at least 7% before taxes an annual return that would double a portfolio over a 10-year period.

To devise such an investment plan, we sought the advice of dozens of financial advisers, while also cultivating our own database of proprietary research. What we found should help you sleep better at night.

The Easy Way Out
One of the simplest ways to get that stable 7% is to buy high-rated corporate debt. Plenty of high-quality, investment-grade corporate bonds and preferred stocks now pay 7% or more and many of the issuers are large, solid companies that you're probably familiar with.

Indeed, the average A-rated 10-year corporate bond is yielding 6.5%. And there are plenty of them to go around each week companies such as General Motors and Ford are issuing high-quality medium-term notes that yield 7% or more. But buying corporate bonds on your own isn't always easy. Typically, you need $100,000 to create a diversified bond portfolio. It also makes sense to buy bonds with a range of maturities a process known as "laddering" in order to spread your risk around.

If you aren't comfortable with the idea of investing in specific companies after all, there's no guarantee that any individual company won't default another good fixed-income option is to look overseas at government debt. Yes, there's a currency risk, but several major countries issue debt with higher yields than U.S. government agencies. Right now 10-year Mexican government bonds, for example, are yielding 7.4%. How safe are they? "Mexico is not perceived as much as it used to be as a Latin credit now it's being seen as a U.S. credit," says Javier Kulesz, Latin American debt strategist at UBS Warburg.

Be careful, though. While bonds promise to deliver stable returns, there are plenty of real risks associated with investing in them. The biggest one is a shift in interest rates. If rates continue to drop, you run the risk of having the issuer call back its bonds early if they're callable, of course which means you'll be dumped out in the market and have to buy new bonds with lower yields. That's admittedly an unlikely scenario now because interest rates don't have much further to fall. On the flip side, if interest rates rise, bonds will lose some of their face value, since bond prices move in the opposite direction of yields. If you hold your bond to maturity, you'll get back your principal. But if inflation is also on the rise, the real buying power of your 7% return will quickly diminish.

If you want diversification and don't have a lot of money to invest in corporate bonds, your best bet is a mutual fund. The problem is that only 21 corporate bond funds offer yields above 7%, according to Chicago fund tracker Morningstar. Luckily, two of them are no-load funds with reasonable expenses: Loomis Sayles Fixed Income and T. Rowe Price Corporate Income. But keep in mind that yields can fluctuate in a bond fund, and returns will vary.

Preferred stocks, which are a cross between a stock and a bond, are another option. As the name implies, holders of preferred stock receive preferential treatment, so dividends are distributed to them before they are paid to holders of common stock. On the flip side of the coin, preferred stock holders are stuck with a fixed dividend payment regardless of any increase in a company's profits.

Like bonds, preferred stocks are callable by their issuer, and they carry a credit risk as well. There are literally dozens of preferred stocks listed on the New York Stock Exchange that pay dividends above 7%. Diane Taylor, a certified financial planner at Hamel Associates in Livingston, N.J., is currently recommending these to her clients: ANZ Exchangeable Trust, Barclays Bank, National Westminster Bank and Westpac Capital Trust.

Finally, consider dividend-paying stocks. They tend to weather the market's bumps better than their non-dividend-paying brethren because when the stock market is dicey, dividends pad returns nicely. And when equities head south, the income stream often limits steep losses.

The bad news is that stocks with big dividends are getting harder to find. In the past decade, the number of S&P 500 companies that paid a dividend fell from 87% to 70%. (That explains why their average yield is just 1.6%.) While the pickings are slim, you can still find ones that pay a healthy dividend. Some of the best options are utilities and real estate investment trusts (REITs). In July the typical REIT dividend was 6.9%, according to the National Association of Real Estate Investment Trusts. You can use the SmartMoney Select Stock Screener to find stocks with high dividends. A quick search on the site gave us tobacco maker UST, which offers a yield of 7%.

Welcome to Diversity City
Bonds, preferred stocks and dividend-paying stocks are all good sources of steady income. But they don't constitute a holistic investment approach. The smartest way to get to that magic 7% is to construct a diversified portfolio among different asset classes with an eye toward limiting your downside, says Jim Kerr, a CFP at Austin Asset Management. Using SmartMoney investment models, we looked at rolling two-year returns from 1945 to the present. We adopted the short view with an eye toward helping investors avoid another devastating two-year period like the one we've just experienced.

Seeking first to minimize the downside above all else, we limited losses to 5% or less over any two-year period. That led us to Portfolio 1 (see page 84), which is heavy in cash (52%) and sprinkled with bonds (18%), large-company stocks (10%), small-company stocks (10%) and foreign stocks (10%). Since 1945, the median annualized two-year return this portfolio delivered was 7.6%, while the maximum two-year downside was 4.9%. The main problem with this portfolio? The hefty cash hoard. "Seventy% of it in cash and fixed income is not diversified enough," says Denny Gustin- Piazza, a CFP at Financial Network in Morton Grove, Ill.

Our investment model in Portfolio 1 was heavily influenced by the fact that both stocks and bonds got creamed during the 1973-74 bear market, when inflation was running in double-digit territory. Over the long haul, this portfolio has held up very well it's lost money only 3% of the time. Yet while cash is considered to be among the most stable of investments, it has its own set of potential pitfalls. As with bonds, inflation can decimate the value of a cash investment.

Next, we tried to create a more balanced portfolio by ratcheting up the stock and bond allocations. Stocks, after all, have delivered annual returns of 11% on average for the past 70 or so years. Yet investors need to be cautious here, too. "There is a very large consensus of opinion suggesting that future returns are going to be a lot less than historical returns over the last 76 years," says Harold Evensky, a CFP at Evensky, Brown & Katz in Coral Gables, Fla.

On the other side of the asset-class spectrum, it's safe to say that the fantastic bond rally we've experienced in the past few years won't last. Interest rates don't have much more room to fall, and most experts, such as Pimco Chief Investment Officer Bill Gross, expect them to begin rising by early next year. With that said, a diversified portfolio should be able to weather any major market shifts. So we tweaked our research model to accept a bit more risk. The result, Portfolio 2, comprises a healthier mix of bonds (25%) and stocks (15% allocations each of large-company and foreign stocks, 10% of small-company stocks). We slashed cash to 35% of the overall portfolio.

Portfolio 2 looks great on the upside, with a median annualized two-year return of 8.5%. The downside? A little more severe, with the model losing 11% during the worst two-year period. Over the long haul, however, this portfolio has lost money over any two-year period just 6% of the time.

Even so, the cash position in this portfolio remains pretty high. So we drilled a little deeper and came up with Portfolio 3, in which we cut the cash stake to a much more digestible 12%. Each stock asset class composes 20% of the portfolio, while bonds make up 28%. The result? A median two-year annualized return of 10.3%. Over its worst two-year period (in 1972-74), this portfolio lost 23.1% 12.3% annually. Not too bad when you consider that the small-stock Russell 2000 lost 20% in the first seven months of 2002 alone. Since 1945 this portfolio has lost money just 8% of the time.

Index funds offer the simplest way to build these diversified, low-maintenance portfolios. Vanguard Group, based in Malvern, Pa., has one of the largest selections of low-cost index funds. You can use, say, the Vanguard Prime Money Market fund for the cash component and Vanguard Total Bond Market Index for bonds. Vanguard 500 Index is a good proxy for small-company stocks; and Vanguard Total International Stock Index for foreign stocks. Plenty of other fund companies, including Fidelity and T. Rowe Price, offer core index products.

Since studies show that two of the most inefficient areas for indexers are foreign investments and small-company stocks, you may want to consider actively managed funds in these two sectors. In the foreign stock fund category, we like the value-minded Oakmark International. Two other good options are Artisan International and Julius Baer International Equity. Both funds have among the best records of any foreign fund during the past five years, delivering annualized returns of 9%. In the small-cap arena, one of the best funds is Buffalo Small Cap, which recently reopened to investors. Another good option is Baron Growth, a top-quartile performer for the past one, three and five years.

You'll have to do some research to find the best cash options. One good source for high-yielding money-market bank accounts is Bankrate.com, which offers a list of the ones with the highest payouts. To search for money-market mutual funds, go to www.imoneynet.com. (Click on "Top Retail MMF Page.") Make sure you read the fine print. Some of the options with the most promising yields lure you in with high "teaser" rates that last for only six months.

One final note: We designed these portfolios assuming that you'll be holding them for at least 10 years, and that the only changes you'll make will be an annual rebalancing of assets when different sectors get out of whack. Of course, that's supposing this approach suits you. Robert Burkett, for one, says he'd be thrilled with a portfolio that guarantees a 7% return. "In today's market, it sounds great to me."

Additional reporting by Chris Horymski

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