Positioning Your Portfolio for Tough Times

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A better hedge against rising inflation risks: floating-rate instruments such as the senior secured term loans that companies secure from banks, says Camarda's Schick. These notes are reset quarterly based on market interest rates, pushing investors' coupon rates higher when rates are rising.

Not only do senior secured bank loans currently yield several hundred basis points more than Treasuries, but investors don't have to tie up their money for long periods to get those higher yields, since the term loans are usually paid off within a year, says Schick. These loans also tend to increase in value because, unlike Treasuries, supply is limited amid stricter lending standards. One sticking point is that the credit ratings of the companies are generally not high and may even be below investment grade. But, as the most secured senior part of a company's capital structure, the term loans are the first to be paid off and are at risk only if a company files for bankruptcy, he says. While these notes are now trading near 90¢ on the dollar, the default rate is much lower than that would imply, around 4%, he says.

Term loans are available in bundled form through mutual funds and closed-end funds. Eaton Vance, the biggest buyer of bank loans, offers the Eaton Vance Floating-Rate Fund (EABLX), which is down 2.48% year-to-date as of July 29, vs. a 3.18% loss in the benchmark Lehman Brothers Aggregate Bond Total Return Index.

Conheady recommends having a 5% allocation in a real estate investment trust (REIT) index such as the Vanguard REIT Fund or a fund holding Treasury inflation-protected securities (TIPS), both of which are more diversified than owning individual TIPS and feature low expense ratios that won't eat up any inflation benefit you're getting.

Minus Emotion

But with banks tightening credit and takeover and new building activity in the doldrums, the times don't favor a bull market for REIT shares, says David Darst, a managing director at Morgan Stanley (MS) and author of the forthcoming book, The Little Book That Saves Your Assets. Instead, he prefers the iShares Lehman TIPS Bond Fund (TIP) as an inflation hedge and uses State Street Global Advisors' SPDR Deutsche Bank International Government Bond Fund (WIP) to protect portfolios from rising inflation worldwide. Given his view that the dollar has already lost nearly 90% of the value it's going to lose, he suggests that 75% of what investors allocate as an inflation hedge be put into the Lehman ETF and 25% into the SPDR fund.

Financial planners don't recommend complex alternative asset strategies such as long/short funds or other hedge funds to clients with less than $1 million because of the high minimum investments and premium-priced fees. But for high net worth investors with $1 million to $20 million saved, a hedge fund such as a 130/30 fund, which uses proceeds from a borrowed short position to buy an additional 30% in long bets on stocks, can help diversify a portfolio, says Darst.

The golden rule for investors is to be patient and to avoid reacting emotionally, says Congdon. "A good allocation strategy will do that—it takes the emotion out of it. At any given time, there will be positions in your portfolio that you will dislike if it's being done correctly."

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Bogoslaw is a reporter for BusinessWeek's Investing channel.