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By timestaff
June 5, 2008

It’s easy to want to play it safe with a large chunk of cash. But being too safe can be a big risk.

Question: I’m 49 years old and have about $1 million to invest. My mother has advised me to put it all in 30-year muni bonds and CDs, but I wonder whether I ought to be more diversified. Do you think I should take my mom’s advice? —C. Hilliard

Answer: Normally, moms are a font of good common-sense advice, encouraging us to eat our vegetables, play nicely with others and, of course, imparting that time-honored admonition: “Don’t run holding that stick. You’ll poke your eye out!”

But as much as I hate to do it, I’m afraid I have to tell you that you should ignore your mom’s investing advice, which is bad on several levels.

Take her muni bond recommendation. Sure, bonds should be part of a well-balanced portfolio and, depending on your tax rate, munis can be an excellent way to get that exposure in taxable accounts, especially today when muni yields are competitive with those of Treasury bonds in many cases, even without factoring in munis’ tax benefits.

But by investing solely in long-term munis – as opposed to also holding short- and/or intermediate-term bonds – you are taking a big risk. The threat isn’t that the bonds might default. As long as you stick to high-quality munis the chances of that are actually pretty slim. Rather, the problem has to do with the seesaw relationship between interest rates and bond prices – namely, when interest rates rise, bond prices fall. And generally the longer the maturity, the steeper the drop.

I’m not in the business of making interest-rate predictions. But given all that Big Ben Bernanke and his colleagues at the Fed have been doing to stimulate the economy, I don’t think it’s a stretch to wonder whether we might be in for higher inflation and higher interest rates at some point in the near future.

But whatever the outlook, I still think it’s best to hedge your bets by sticking to bonds, or bond funds, with maturities at the short- to intermediate-end of the maturity spectrum. You’ll collect most of the yield of longer-term issues with much less volatility.

But the even bigger problem with mom’s recommendation is that it would leave you with all of your money in fixed-income investments. That might be fine if you were, like, 90 years old. (Even then, 100% in fixed-income wouldn’t automatically be the way to go.) But you’re a mere youngster of 49, for goodness sake. At this point in your life, you still need some long-term growth to boost the purchasing power of your portfolio so it can support you throughout retirement. And to get that growth, you’ve got to diversify into stocks.

So the challenge you face is putting together a diversified portfolio of stocks and bonds that gives you a decent shot at long-term growth but also provides enough stability so that your portfolio won’t get totally hammered if the stock market drops or interest rates rise.

In order to meet that challenge, you’ll have to grapple with two fundamental questions: How should you divvy up your holdings between stocks and bonds? And then, which types of stocks and bonds should you invest in?

There are no one-size-fits-all answers. It largely comes down to how much risk you’re willing to take, what size returns you want to shoot for and how hard you want to work at creating and then monitoring your portfolio. But you can get advice both on how to allocate your holdings between stocks and bonds as well as on specific investments by checking out this month’s Money cover story, “The Only 7 Investments You Need Now.”

I’ll leave it to you as to the best way to handle your mother if she asks you whether you followed her advice. But there is a way you can be truthful but also let her down easy. Just say, “Remember, mom, how you always told me to eat a balanced diet? Well, I’m applying your excellent advice to my investment portfolio.”

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