Your Post-Subprime Portfolio

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But in February the market seized up, trapping Newton's money. Insurance companies backing some auction-rate securities had hit the skids because of subprime losses, and no one wanted to buy the securities.

The lesson is to avoid reaching for extra yield, especially in arcane or unusual markets, says Needham (Mass.) financial adviser Debra Brede: "Don't be a hero."

"RECESSION-PROOF" STOCKS AREN'T

As the U.S. economy began slowing last year, pundits recommended that investors favor more defensive sectors such as health care, which was among the best-performing industries in the past three recessions. With this economic slowdown, however, that advice has proved to be off-base. State Street's Health Care Select Sector SPDR exchange-traded fund, which tracks the performance of all health-care companies in the Standard & Poor's (MHP) 500-stock index, has lost almost 13% this year, the third-worst performance of any sector.

Several factors have hit health-care stocks, including plans by both John McCain and Barack Obama to cut costs out of the system. And the biggest companies in the sector, pharmaceutical giants such as Johnson & Johnson (JNJ) and Pfizer (PFE), are facing an onslaught of competition from generic drugs even as their pipelines of new blockbusters appear nearly empty. "There haven't been too many places for health-care stocks to hide," says David Kovacs, chief investment officer at Turner Investment Partners.

DIVIDEND FUNDS PROVIDED NO HAVEN, EITHER

After taxes on dividends came way down in 2003, Wall Street cooked up a plethora of new dividend-oriented funds, such as the iShares Dow Jones Select Dividend Index (DVY DVY DVY), which hit the market in November 2003 and quickly attracted more than $1 billion in assets. Part of the pitch was that stocks that pay high dividends perform better if the market turns down. But the funds had an Achilles' heel, which was revealed when the subprime crisis struck: A large proportion of the stocks that pay high dividends were in the financial-services business, the sector hit hardest by subprime losses. The now $5.8 billion iShares fund lost 29% over the past year, trailing the yield of the S&P 500 by more than 16 percentage points.

Financial advisers say investors need to pay more attention to the risks of such concentrated portfolios. One way to hedge those risks is to avoid owning far more of the stocks in a particular sector than are represented in the market overall. So if a dividend fund owns a large portion of financial stocks, investors could cut back on financials elsewhere in their portfolios, says money manager Roger Nusbaum of Your Source Financial, a Phoenix wealth-management firm. That can be more time-consuming than just buying a couple of exchange-traded funds, he acknowledges. "Unfortunately, there are no shortcuts for do-it-yourself investors," he says.

INTERNATIONAL DIVERSIFICATION ISN'T ENOUGH

Academics like to call the benefit of diversifying your portfolio the only free lunch in economics. Over long periods, they've noted, combining different kinds of assets can offer a higher return with less volatility. But it's key that the investment niches truly differ—they have to zig and zag at different times, a feature academics call low correlation. A decade ago, U.S. investors discovered the benefit of adding international equities to their portfolios. Through much of the '80s and '90s, moves in the S&P 500 had only about a 50% correlation with the MSCI EAFE Index, which tracks other major markets.

But that correlation rose to over 80% in the past few years, eliminating much of the benefit, according to research by Ibbotson Associates. It turns out that as big companies increasingly do business across the globe, the returns of their stocks become more similar. Since October, in the wake of the subprime crisis, the MSCI EAFE is down 15.36%, while the S&P 500 is down 15.65%. That means investors need to look beyond overseas stocks to diversify. Commodity index funds, real estate investment trusts, and bonds all offer far lower correlations, notes Ibbotson's chief investment officer, Peng Chen.

Return to the 2008 Retirement Guide

Pressman is a correspondent in BusinessWeek's Boston bureau.