Seeking the Sweet Spot

Idzorek points out that emerging-markets stocks and bonds have moved counter to the broader market—sometimes significantly—in five of the 16 years for which Morningstar has data on these investment vehicles. “Going into any given year, it is very difficult to say which asset class will be the winner. Therefore, if you have an emerging-markets stock fund and a bond fund, you are likely to have a smoother ride, long term, than if you have only one type of fund.” However, he warns that investors shouldn’t overload on emerging-markets stocks or bonds, expecting the high returns of recent years. “Perhaps 10% or even 5% of a diversified portfolio should be in the emerging markets,” he says. A modest dose of emerging markets, split between stocks and bonds, might give your portfolio a boost over the long term without putting you on a breathtaking roller coaster ride.

CERTIFICATES OF DEPOSIT (CDs)

Traditionally, a balanced portfolio
includes some cash as well as stocks and bonds. Today, though, cash equivalents have scant yields: the average money market fund yields only $5 a year (0.05%) on a $10,000 deposit. “You can do better with bank certificates of deposit (CDs),” says Greg McBride, senior financial analyst at Bankrate.com, based in North Palm Beach, Florida, “especially if you shop the Internet for the best deals. Today, the average yield on a one-year CD is only 1%, but the highest-yielding one-year CDs are paying around 2%.” Safety is not really an issue if you get a CD from a bank that’s a member of the Federal Deposit Insurance Corp. (most are). The FDIC insures up to $250,000 per account, per bank.

McBride warns against buying long-term CDs today. “It doesn’t make sense to lock up your money for three or five years at the interest rates being offered now,” he says. Instead, he suggests constructing a “ladder” of CDs maturing in three, six, nine, and 12 months, then renewing them as they mature. When interest rates start to move up, perhaps in 18 months or two years, you’ll have cash from maturing CDs that you can reinvest at higher yields. “If you’re years from retirement, you should have no more than 10% to 15% of your portfolio in CDs,” says McBride. “As you grow older, you may want to have more money there, for safety and for current income.”

DIVIDEND-PRODUCING STOCKS

If only 5% to 10% of your portfolio is allocated to emerging markets, you probably should hold stocks from the U.S. and other developed nations as well. In order to minimize exposure to a free fall like the one we all experienced in 2008, you might want to include dividend-paying stocks. “Look for companies that have enough net income to easily cover the interest on their debt and the dividends they pay to shareholders,” says Eugene Profit, CEO of Profit Investment Management (No. 15 on the be asset managers list with $900 million in assets under management). “Those companies have strong fundamentals so they are likely to hold up well in any economy.”

What’s more, current law calls for stock dividends to be taxed at no higher than 15% through 2010. (Bond interest, on the other hand, may be taxed as high as 35%) “No one knows what will happen in the future,” says Profit, “but it’s possible that stock dividends will continue to have favorable tax treatment because many seniors rely on those dividends for retirement income.”

Overall, Profit suggests mixing high-dividend stocks with growth-oriented equities that pay little or no dividends. If you are getting an overall 2% to 3% yield from the stocks in your portfolio, you might have current income, upside potential, and downside protection if stocks slump again.

Among his firm’s current holdings, Profit is especially keen on these dividend-paying stocks:

Verizon (VZ) This telecom giant, the largest wireless carrier in the U.S., now has a dividend yield of more than 6%. “The company may get the rights to sell the iPhone in the next year or two,” Profit says. “In the meantime, the high dividend means investors are being well-paid to wait for news that might boost the company’s stock price.”

General Electric (GE) This company has been included in the financial sector because of its GE Capital subsidiary. As a result, its stock price has suffered in the credit crisis. “GE really is an industrial company, not a bank,” says Profit. “It is well-positioned to increase earnings as the economy recovers.” Meanwhile, it offers a well-covered 5% dividend yield.

United Parcel Service (UPS) Profit puts the current dividend yield at 3.25%, which is as high as or higher than you’d get from most bank accounts or Treasury bonds. “In addition,” Profit says, “UPS has the highest profit margins of any major company in the transportation industry. So investors might see its stock price move up when the economy improves.”

Home Depot (HD), with a current yield of 3.40%. “Shelves look empty at Home Depot these days as homeowners launch do-it-yourself projects and hire contractors, either to help sell their homes or make them more comfortable because they’ll be there for awhile. Also, management is making an effort to be more customer-friendly,” says Profit. The company’s current dividend yield is around 3.4%.

Johnson & Johnson (JNJ), with a current yield of 3.2%. Profit admits that healthcare stocks have been up and down with all the talk of federal healthcare reform. “Once that’s resolved,” he says, “the basic fundamentals will emerge: an aging nation and an aging world mean more demand for healthcare. J&J offers the best combination of safety, upside potential, and yield among dividend-paying stocks in that sector.”

“MUNI” BOND FUNDS

During the stock market crash of 2008–2009, bonds outperformed other traditionally “defensive” assets such as gold and (naturally) real estate. The best way to protect your portfolio from stock market volatility, therefore, is to hold some bonds. “Today, you can easily get higher yields from municipal bonds than you can get from Treasury bonds,” says Mike Nozzarella, managing director at the Tarbox Group, a wealth management firm in Newport Beach, California.

Munis pay tax-exempt interest while the interest from Treasuries is taxable, so the former will generate much higher yields after taxes. As of mid-October, 10-year Treasury bonds yielded 3.25%. If you are in a 28% federal tax bracket, for example, you would keep only 2.34%, after tax. “High-quality municipal bonds maturing in seven to 15 years now yield around 4% to 5% tax-free,” says Nozzarella. That’s a tax-exempt yield so you’d collect almost twice as much as you’d net from a taxable Treasury bond.

Investing in municipal bonds is far from straightforward. Among the points to consider:

Credit quality. State and local governments face financial pressure now so the risk of default has increased. “For safety, buy GO [general obligation] munis,” says Nozzarella. “It makes sense to sprinkle in some general obligation bonds because you can pick up some yield, but don’t be greedy. There is no question that states like California have serious budget issues and the GOs are backed by the state’s ability to impose taxes (and raise revenue through higher taxes). However, California issued IOUs earlier this year, so it’s not the ‘safe’ play, as much as it is the ‘calculated risk’ play.”
Munis are backed by the full taxing power of the issuer so defaults are unlikely. You’ll also be safe owning bonds issued to fund essential services such as schools, water supply, and sewer treatment.

Call features. In today’s muni market, investors often pay a premium: you might pay $1,100 for a $1,000 bond, for example. Once the bond matures you’ll automatically lose $100. That’s acceptable if you get a high yield and your loss at maturity is many years away. However, some munis may be “called” (redeemed prematurely at face value), reducing your income stream and accelerating your loss. “Always ask your broker or adviser about the yield-to-call,” says Nozzarella, “to see what your true return will likely be.”

If you’d rather not master the intricacies of the muni market, you can simply invest in a municipal bond fund. Funds holding intermediate-term munis may generate decent yields with relatively low risks. “A moderately aggressive investor might hold 20% of his or her portfolio in municipal bonds or muni funds,” says Nozzarella.

Indeed, adding just the right mix of each of these investments—emerging-markets bond funds, CDs, dividend-producing stocks, and municipal bond funds—should help you cultivate sweet, low-stress returns.

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