Unlocking a safer, smarter portfolio

RORO has made a mess of a lot of carefully designed portfolios.

RORO isn't what George Jetson's dog used to say. It's trader jargon for "risk on/risk off." Investors pile into risky assets -- especially stocks, both U.S. and foreign -- when the economic news is bright, and run for cover into Treasuries at the first whiff of trouble.

Even if you're a steady buy-and-holder, RORO has left its mark in two big ways:

First, diversification is harder. A classic way to reduce your volatility is to own different kinds of assets, so that when one part of the market falls, something else may be going up -- or at least falling less. RORO wrecks that. It first roared in the 2008 crisis, when not just U.S. stocks but foreign stocks, high-yield bonds, real estate, commodities, and you-name-it all crashed.

The HSBC RORO index, which tracks how closely assets correlate, or move together, kept rising from there. It stayed near historic highs through late 2012.

The mood-swing trade has tailed off this year, but that's because U.S. stocks boomed as Europe and emerging markets dragged. So spreading your bets with international stocks didn't help you in the crisis and isn't boosting your returns now.

In any case, it's too early to declare an end to RORO, says HSBC strategist Mark McDonald. With the global economy still vulnerable to crisis, a raised eyebrow from Ben Bernanke or a European finance minister may be enough to set off an undiscriminating tizzy. "Any market hiccup can cause correlations to spike again," says McDonald.

Second, safety is getting risky. One investment that has smoothed your ride is the safe haven everyone runs to at "risk on" time: Treasuries. They're now so popular that the yield on a 10-year note is down to less than 1.8% (When bond prices rise, their yield falls.)

That creates some problems: Yields have little room to go anywhere but up from here, which means you could experience sharp losses when interest rates, and thus yields, start to rise again. What's more, holding bonds at these rates means you risk seeing your investment's value eroded by even a moderate amount of inflation.

How, then, in this twitchy environment, do you build a portfolio safe enough to let you sleep at night, with returns that get you to your goals? Money dove into the best research on diversification and talked to some of the sharpest advisers. The big takeaway: With only a few twists, you can still hedge against the risks that really matter.

What follows are five key ideas to guide a long-term investor through a market where everything turns on the latest news flash.

KEY IDEA NO. 1

Forget the short-term, protect against generational risk

The idea that other countries' markets will move out of step with the U.S. is an important part of the pitch for international mutual funds and ETFs. ("Diversification" is literally the first word on T. Rowe Price's "International Investing Explained" web page.) This has become a harder case to make, however.

Consider the relationship between U.S. equities and an index of developed markets. A 100% correlation means markets always move together; zero is no relationship at all. Since the '70s, correlations have shot up from 37% to 88%.

What happened? Globalization. "As the world becomes increasingly interconnected, macroeconomic events are more often driving market movements," says Tyler Shumway of the University of Michigan business school. Companies in Europe or Asia do much of their business here, and vice versa.

Even the fact that you can easily diversify abroad with a mutual fund makes it harder, ironically, to reap the benefits of diversification. The anxieties of investors in Florida can feed through to stock prices in Frankfurt.

Step back from the short term, though, and diversification still looks powerful. William Bernstein, a Portland, Ore., investment adviser, says it protects against risks that play out over decades -- like a slump long enough to blow out the gains of a generation of investors. That happened to Japanese investors after 1989.

To be blunt: Owning overseas is a hedge against the unlikely but real possibility that you'll someday find yourself living in the next Japan. Research from AQR Capital Management shows that while countries often fall together in the short term, long slumps are something nations often do on their own.

In a decade in which Japan fell 40%, in fact, a global portfolio rose 130%. "Global exposure helps you cut out the risks of investing in a single country," says Gregg Fisher of advisory firm Gerstein Fisher. And that includes your own country.

How to retool: Over five years foreign equities have lost an annualized 1.4%, vs. a 4.9% gain for the S&P 500. If disappointing performance led you to lighten up on foreign shares or to stay out, this year's divergent markets may offer a window to get in. The stocks in Fidelity Spartan International look relatively inexpensive, trading at about 13 times next year's expected earnings, compared with 14.3 for the S&P. "Smart investors go fishing in troubled waters," says Bernstein.

How much do you want to own? A third of your stocks is a baseline. Though the short-term diversification benefits of going abroad have declined, they haven't disappeared. A report by Vanguard found you get most of that advantage with a 30% allocation.

The same report also revealed something surprising: "Emerging markets are almost as correlated with the U.S. as is the rest of the developed world," says Vanguard's Christopher Philips. These riskier markets might be attractive for their return potential, but there's no need to add a lot just to be diversified.

A broad international fund with around 15% in such countries, like Money 70 picks Dodge & Cox International Stock or Vanguard Total International Stock gives you plenty of exposure.

Key Idea No. 2: Some stocks beat others

KEY IDEA NO. 2

Markets may move in sync, but some stocks beat others

The demise of easy stock diversification (at least in the short run) means there's one less obvious strategic edge available to individual investors. A bulwark against disaster is good -- but is there any way to actually capture a better return along the way?

Research into the history of financial markets has found few strategies that offer a long-term advantage. Two that might: owning small-company and value stocks, or shares that trade at a deep discount to earnings or business value. Small-caps beat blue chips by an annualized two percentage points since 1927, according to Morningstar data; large value beat pricier large growth stocks by about as much. Stocks that are small and cheap won even bigger.

The idea of tilting your portfolio toward some corners of the market pushes against the idea of spreading yours bets as widely as possible.

However, Larry Swedroe of Buckingham Asset Management says you can use tilt as part of a strategy to lower your overall exposure to risky assets. He's found that since 1970, a portfolio with 50% in bonds and the rest split evenly between an S&P 500 index fund and a U.S. portfolio of small value stocks would have matched the long-run return of a fund with all of its assets in the S&P, with less volatility.

Two big caveats: First, the future might not look like the past. Second, this approach takes guts, even with a bigger bond stake. The reason small caps deliver better performance is that they clearly are risky. And although value investing is often thought of as conservative, stocks are often cheap when the market sees trouble ahead.

Besides, when bull markets take hold and "go-go" growth stocks soar, being a value investor can make you feel like a chump. "Way more important than your specific mix of assets is your commitment to keep your money invested through thick and thin," says investment adviser Rick Ferri of Portfolio Solutions.

Sticking to a tilted portfolio, which is bound to be out of step at times, requires extra commitment.

How to retool: You don't have to go whole hog on this strategy. Adding even a style-focused ETF like Vanguard Small Cap Value gets you some tilt. Or, says Daniel Solin, also a Buckingham adviser, you could add the value and small-cap factors separately, with Vanguard Value Index and Vanguard Small Cap Index .

If more than 50% of your overall stock mix is in value, and more than 10% is in small caps, you're tilted. A similar strategy can also be applied to your foreign holdings using iShares MSCI EAFE Value and iShares MSCI EAFE Small Cap .

KEY IDEA NO. 3

Bonds are your frenemy

While correlations within the stock market have risen over the years, Treasuries, the core of many bond portfolios, are now negatively correlated with equities -- they often move in the opposite direction. That would be great, if their sub-2% yields didn't make them such unappealing investments.

"You're not necessarily being compensated enough for the interest rate risk looming around the corner," says Peter Palfrey of Loomis Sayles Core Plus Bond Fund, putting it mildly. The duration, or interest rate sensitivity, of a 10-year Treasury is 8.8 years, meaning a one percentage point spike in rates would cut its price 8.8%.

The lack of yield is a big enough worry that veteran investment adviser Charley Ellis, a longtime advocate of a passive buy-and-hold approach to investing, told Money in an interview last month that his best advice is to not own bonds.

The tough question is, What would you do instead? Adding a lot of equities can't be the answer. As the Cyprus crisis earlier this year showed, the global economy is hardly out of the woods yet; bonds will probably still be a cushion in future stock shocks. Cash or CDs are an option for safety, but that means living with yields from barely over zero to 1%.

How to retool: Although not as safe from a rate spike as cash, Treasuries with durations below three years still offer a reasonable amount of protection from a rate turn.

Wealth manager Chris Cordaro of RegentAtlantic Capital also suggests that you diversify with some highly rated corporate bonds. They don't add much risk of default, and the higher yields they pay give you an extra cushion against an interest rate move. Vanguard Short Term Bond , a low-cost ETF, is mostly Treasuries, but keeps about 20% of its portfolio in high-grade corporate bonds.

Also look beyond the U.S. "Foreign bonds give you good value today, with better yields than Treasuries for income and protection against interest rate risk," says Bohemia, N.Y., financial planner Ronald Rogé. He suggests that you make foreign bonds about 10% of your bond stake. Pimco Foreign Bon d is a solid choice that employs hedges against currency risk -- the possibility that falling foreign currency knocks out some return.

Finally, if going shorter leaves you hungry for income, consider a change on the stock side of your portfolio. "Many good-quality stocks can get you 3% or 4% yields right now," Rogé says. SPDR S&P Dividend , an ETF, currently yields 2.8%; the Vanguard Value Index Fund's yield is 2.5%.

KEY IDEA NO. 4

Inflation is worth fighting

Shortening-up addresses the interest rate risk in your bond portfolio. Another risk remains on the table: inflation.

Rising prices haven't been much of an issue in this slow-growth economy -- and many economic experts say they may not be for some time -- but a diversified portfolio isn't about protecting against what's likely to happen. It is insurance against painful shocks.

Boston University economist Zvi Bodie notes that the long-run forecast for inflation is about 2.5% a year. "But I am highly uncertain," he adds. "I would not be very surprised if it turns out to be 4% or 5%."

The good news is that the U.S. Treasury sells really effective insurance against inflation in the form of bonds called TIPS, which adjust their principal value in line with rising consumer prices. The bad news is that the yields on them are really lousy -- in fact, they are now -0.64%. In other words, you are guaranteed to lose a bit of money on them if you hold to maturity.

Who'd take the government up on an offer like that? You might, once you know that -0.64% represents the real, or after-inflation, yield. Buy a normal 10-year bond yielding 1.73% and you will lose just as much if inflation runs a moderate 2.37%. If it's higher, you'll lose more. Although TIPS can't fix the fact that yields on all kinds of Treasuries are low, they do deliver truth in advertising and probably better real yields than savings accounts or CDs.

How to retool: TIPS are as vulnerable to interest rate risk as any Treasury, so for the most part short is the way to go. Pick the low-cost Vanguard Short-Term Inflation Protected Securities or buy short-maturity TIPS directly at TreasuryDirect.gov.

As for how much you need to hold in TIPS, consider your life stage. "The average person might have half TIPS and half Treasuries," says Swedroe. (So if you have a bond fund that's mostly regular Treasuries, you'd dial back that investment to add a TIPS fund.) He adds that older people will want a bit more, since inflation poses the most serious threat to those dependent on investments for income. Younger people still in the workforce need fewer TIPS.

Unlike with regular Treasuries, there's a case for owning longer TIPS, but individually, not in a fund. If you need to protect money with no chance of a surprise loss, a TIPS bond protects purchasing power (minus that negative yield). That's provided, of course, you know for sure you will hold until maturity.

KEY IDEA NO. 5

The new diversification tools Wall Street sells are already rusty

Wall Street's response to high correlations and lousy bond yields has been to sell "alternatives" -- a mixed bag of everything from commodity futures to hedge fund strategies. Avoid these often expensive funds.

The diversification and return potential of alternatives is overstated, argues William Bernstein in the e-book Skating Where the Puck Was.

Commodities futures, for example, had amazing records a decade ago. They beat bonds and stocks, and correlated with neither. But new indexes, funds, and ETFs now mean that anyone can pile into futures -- and they have. As the market has become crowded, returns have been lower, and correlations have risen too. When investors were running for the exits in 2008 and 2009, they dumped their futures bets along with their stocks. "The moment you securitize an asset, you begin to destroy its diversification benefits," says Bernstein.

The same applies to hedge-fund-like strategies such as "absolute return" and "market neutral." By the time such strategies get to retail, they may be too well-known to work.

There's no magic combination of assets that will make you a winner every year. Cover the big dangers -- a long slump, a rate turn, and inflation -- and leave RORO worries to Wall Street's hyperactive set.