3 Rules for Positive Returns in 2011

Diversify, cut risk, and rebalance.

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The year 2010 proved fruitful for the markets. However, 2011 is uncertain. How investors choose to position their portfolios this coming year could have a significant impact on their future.

Today, the market is looking for direction. With high unemployment, poor credit facilities, a questionable healthcare system, and various other issues, investors must plan for growth and stability in the year to come.

We are still in a range-bound market. Returns increase in spots when good news presents itself, but then they drop to a common low when another country reveals its financial issues. This has gone on for several months, with no end in sight.

[See 8 Investing Resolutions for 2011.]

How should investors arrange their portfolio in this type of financial environment? Certainly not in the traditional way. Remember the definition of insanity: doing the same things over and over and expecting different results. You must think differently.

There are three rules that could prove instrumental in the quest for positives returns. First, add more diversification. Most people ask how "the market" is doing. A good follow up question would be: what market? There are numerous markets to invest in, but the average investor does not utilize even a fraction of them. Invest in the stock markets of the world—diversify, diversify, diversify.

The average investor builds a portfolio of stocks, bonds, and cash in the United States, then adds an international fund for good measure. Nowadays, that strategy is not well-diversified. A solid portfolio should encompass many more markets.

Build a better portfolio by including large-cap, mid-cap, and small-cap growth and value stocks. Next, add government, corporate, and high-yield bonds and limit their maturities as interest rates rise. Sounds pretty basic so far, but here is the kicker: For your international positions, think more globally. Utilize currencies, commodities, global real estate, and global bonds. This is where you find real diversification. Each of these investments is available through mutual funds or exchange-traded funds at the retail level, so anyone can invest in them.

[See Zen and the Art of Asset Allocation.]

Second, add investments that automatically reduce risk. Certain investments can have a risk-lowering effect on your portfolio. Tools like long/short funds, which allow the manager to buy into securities he thinks will increase in value and sell short those he thinks will decrease in value.

Also, add absolute return funds. This type of investment requires that the manager always strive for a positive monthly or yearly return. Sometimes, the manager will give up an opportunity to keep the portfolio positive, which definitely reduces risk.

Finally, add managed futures into the mix. Managed futures are an asset class that allows a manager to invest long and sell short in vehicles like commodities, currencies, or even oil. These volatile assets are used every day in every country and are traded in very liquid markets. The beauty of using this type of investment is that it has the tendency to provide an average return in good years, but blow the cover off the ball in poor years. Consider that in 2008, when the stock market lost 38 percent, most managed futures portfolios generated a positive return of 30 percent to 40 percent. Even if managed futures accounted for only 5 percent of your portfolio, they could've had a significant impact on your portfolio's overall performance.

Finally, rebalance versus market time. Investors are always trying to decide when to get into an investment and when to get out. In other words, they are trying to time the market to increase their investment return. That simply does not work. A better solution would be to rebalance your portfolio. In other words, determine what asset classes to include in your portfolio and choose the percentages, then stick with them. Monitor the percentage breakdown of each asset class on a monthly basis and if any one is more than 5 percent misaligned, adjust it.

Think about what rebalancing is doing. If an asset class is over-weighted in your portfolio, sell some of it and put those proceeds into the one that is under-weighted. Essentially, when you rebalance, you are buying low and selling high. Isn't that what we were always told to do?

While these rules will not guarantee success, they will give you a much better shot at it.

Kelly Campbell, Certified Financial Planner and Accredited Investment Fiduciary, is founder of Campbell Wealth Management, a Registered Investment Advisor in Fairfax, Va. Campbell is also the author of Fire Your Broker, a controversial look at the broker industry written as an empathetic response to the trials and tribulations that many investors have faced as the stock market cratered and their advisors abandoned their responsibilities to help them weather the storm.