If you want to follow fads, you’ll find plenty of them in investing. Technology and telecommunications. The Internet. Small-cap companies. Even international stocks are getting more attention than they’ve seen in years.

But many people have much more enjoyable and interesting things to do with their time than follow investment trends. Are they doomed to be left out of "the action" and stuck with second-class returns? We don’t think so.

Several decades of research has consistently shown that long-term investors who choose wisely can build a portfolio of stocks and bonds that, left to its own devices, is likely to give them a premium return for the risk they have taken.

Investors in this country regard the Standard & Poor’s 500 Index as a proxy for "the market," and we’ll do so too in this article. Drawing on Nobel-Prize winning research, I will argue that investors who carefully use 10 specific asset classes can, over time, achieve higher returns than the market while they take no more risk than that of the market. And in many cases they can do this at less risk than that of the S&P 500 Index.

The trick lies in identifying kinds of assets that historically give investors a premium for taking risks. If you had only two choices, Treasury bills or the Standard & Poor’s 500 Index, it would be easy to see that the S&P 500 Index is more risky. And usually (but not always), the S&P 500 Index gives investors a higher return. That higher or "excess" return is called a premium, and it’s the reward for taking the higher risk.

If you’re an equity investor, you can regard the S&P 500 Index itself, instead of Treasury bills, as the benchmark, the standard to meet or beat. Remember, the S&P 500 Index is made up of stocks of large U.S. companies. And numerous studies have identified other kinds of stocks that are riskier than large U.S. stocks – but that give investors additional premium returns in exchange for taking that extra risk. That’s exactly what we look for when we build a buy-and-hold portfolio

There are three basic ways to get that premium for risk: international stocks, small-company stocks and value stocks. Later in this report, we’ll discuss each of these conceptually.

Our studies indicate that in the past if you had balanced the Standard & Poor’s 500 Index with these major asset classes, over long periods of time you would have achieved a higher return that the S&P 500 Index alone – at less risk. That’s right, higher returns at lower risk. That’s what it’s all about.

Here are two ways this can improve your portfolio:

If you want the returns of the Standard & Poor’s 500 Index, you can achieve them through proper diversification, with as much as 30 percent of the portfolio in bonds. That’s a significant decrease in risk.

If on the other hand you are willing to assume the risks of owning the Standard & Poor’s 500 Index, you can achieve substantially higher returns through proper diversification.

Now let’s look at these extra-risk, extra-return asset classes, one at a time. Using data from Dimensional Fund Advisors (DFA), we looked at long-term returns of the asset classes favored by academic research. For each asset class, the following table shows annualized returns through the end of 1999 for 20 years, 30 years (where available) and for the longest period for which we have data. (The maximum period, indicated in the table, varies for each asset class.)

As you can see, over 20 years, only U.S. small value stocks and international value stocks had higher returns than the Standard & Poor’s 500 Index. (Ironically, those two asset classes are currently very far out of favor with investors, making them relatively good buys at this time.) But in the longer term, each of these other asset classes outperformed the S&P 500 Index.

We don’t show large U.S. growth stocks in the table. Even though they are all the rage lately, over many decades they have lower returns than even the Standard & Poor’s 500 Index. Large U.S. growth stocks also have the lowest levels of risk, because these companies are popular for their healthy financial positions, superior management, strong prospects and they often have a competitive edge. In short, they are relatively excellent companies with below-average risk. And investors who take less risk should expect to get less return.

This all sounds very obvious, doesn’t it? But the implications of this apparently are not so obvious to many investors, who keep throwing money almost exclusively into U.S. growth companies as they chase high returns that are an anomaly. Repeat: those high returns in U.S. growth stocks are nice. But they should not be expected to continue over the long run.

That is the whole point of diversifying.

I have no proof that these other asset classes will someday outperform the Standard & Poor’s 500 Index. I have only the evidence of history, which is filled with temporary periods when a certain asset class takes center stage and gets all the attention. And history is filled with instances when investors who focused on center stage, ignoring everything else, got burned when the spotlight suddenly moved.

I have no way to know when investors will see a return of the higher premiums historically paid by small stocks, international stocks and value stocks. Small-cap stock funds seem to be making a comeback, and they may have already started to turn the corner. The same might be true of international stocks.

But these are issues of short-term timing, which should be only a minor concern to long-term investors with a buy-and-hold approach.

Let’s very quickly review the reasons that certain assets pay premium returns.

The case for stocksThe case for stocks: High-grade corporate bonds are considered very safe, because they represent a promise to pay specific amounts of money at specific times. And owners of bonds have a higher claim on the assets of a company than do any stockholders. Since 1926, long-term corporate bonds have produced an annualized total return of 5.6 percent. In that same period, as we saw, large U.S. stocks, represented by the S&P 500 Index, had an annualized total return of 11.3 percent, almost exactly twice as high. Investors took more risk owning stocks, and they were amply rewarded for doing so.

When I say "amply rewarded, " I mean it. The difference between an annual return of 5.6 percent (bonds) and one of 11.3 percent (stocks) is modest over a few years, but over decades, it can be overwhelming. The following table shows the compound results of an initial investment of $1,000 at these two rates over five years, 10 years, 30 years (a typical adult investor’s time horizon) and 60 years (a reasonable time horizon for a 25-year-old investor just starting out).

The case for international stocks: International companies aren’t necessarily better than U.S. companies. In fact, they are riskier in some ways. Most international stock markets aren’t regulated as tightly as those in the U.S. It’s often harder for U.S. analysts to get reliable information on foreign companies. And overseas enterprises are subject to currency, political and social risks that don’t seem to exist in the United States. For all these reasons, investors should expect to receive a premium return for taking higher risks, and that’s what has happened over long periods of time. As we saw in the table, since 1970 international stocks, both large and small, have given investors higher returns than the Standard & Poor’s 500 Index. I see no reason to think that won’t continue to be the case in the long-term future.

The case for small-company stocks: Small companies are more risky than big companies because they simply don’t have the resources of big companies. Critical resources include deep financial pockets, massive borrowing power, big sales forces, well-entrenched product lines and (sometimes this matters) political clout. Small companies may not have the cash to develop new products or conquer new territories. Small manufacturers may have a tough time capturing retail shelf space that’s desired by their big competitors. For example, Microsoft Corp. in 1986 (the year its stock went public) was an interesting company, even an exciting one. But at the time it was only one among more than a dozen important software companies. It had only a few hundred employees. And its chairman and guiding light, a young Bill Gates, still looked like the college dropout from Harvard which he still is. The Microsoft of 1986, in short, was much riskier than the Microsoft of 2000. On the other hand, young companies sometimes grow much faster than old ones. And small companies can be easily acquired by bigger companies. In short, small-company stocks are both riskier and more rewarding than large-company stocks. Sometimes small companies go out of favor. (For more on this, visit our Web site and look up an interesting article from July 1999 called "In stock investing, size matters.") But over the long haul, small companies have produced higher returns than large ones.

The case for value stocks: Value stocks are risky by definition. They are companies that for any number of reasons are out of favor with investors. It all boils down to this: These companies are suffering from either real or perceived financial distress. They are "unexcellent" companies in the eyes of investors. Surprisingly, these down-and-out companies over long periods of time turn in better stock performance than their healthier, more popular counterparts. This is confirmed in study after study. One main reason is that investors often go overboard in ditching companies with temporary problems, turning many of those companies into stock-market bargains. Not every "dog" stock turns into a winner, of course. But indexes of hundreds or thousands of beaten-down stocks tend to outperform indexes of popular growth stocks. Incidentally, the Standard & Poor’s 500 Index is not exclusively made up of either growth or value stocks; it’s a blend of the two, weighted about 70 to 80 percent toward growth stocks.

Below, you will find a table showing year-by-year results of our diversified all-equity buy-and-hold strategy, compared with those of the Standard & Poor’s 500 Index. Our diversified strategy splits equity investments equally between U.S. and international stock funds. Each half of the portfolio includes roughly equal measures of small, large, value and a blend of value and growth. The international side also includes a small amount of emerging markets funds (starting in 1990, when data is available to track that asset class).

The results speak for themselves, especially the growth of initial investments of $1,000. In tables like this we usually list risk factors at the bottom, showing figures for each strategy’s worst one, three, 12 and 36 months, etc. In this case, there’s no need for those lines. In every single measure of risk, the global portfolio was more favorable than the Standard & Poor’s 500 Index. Combine that fact with the much higher cumulative returns and this is a no-brainer comparison, in my opinion.

At this point I’d like to say a few things about market risk – the possibility that the market goes down and takes your funds with it – in an investment portfolio. Because the market has a strong upward bias on a long-term basis, we’ll assume that losses are temporary and will eventually be overcome. But sometimes recoveries take a long time, and in the meantime you might need your money.

There are just two basic ways to handle market risk. One is to have a strategy that gets you out, or partially out, when the market is going down – and that gets you back in when the market is going up. But that’s market-timing, not buy-and-hold investing, so we’re not even considering it here. That leaves only one way for a buy-and-hold investor to control risk: including fixed-income securities in the portfolio.

An all-equity portfolio will always have substantial risk. You’re exposed all the time to substantial, sudden losses. But a portfolio that’s balanced 50 percent in stocks and 50 percent in bonds will be subject to much less volatility. Its return won’t be as high as that of an all-equity portfolio, but in most years bonds provide a positive total return, and this return contributes to an investor’s overall return.

There are very few decisions that are more important for an investor to make than how much fixed-income securities will go into a portfolio. Put in too much fixed income, and you could give up return that you need to achieve your needs or objectives. Put in too little, and you could lose so much from the equity side of your portfolio that you’ll get discouraged and have trouble staying the course for your portfolio.

I believe almost all investors should have at least some equities in their portfolios, to protect them against inflation and let them participate in the growth of the world’s economic base. But I also believe that most investors should have at least some fixed-income funds in order to temper the volatility of equities.

To determine the proper equity/fixed income balance for your own portfolio, you will need to think carefully about your tolerance for risk. Don’t look only at how you feel and what you think about risk. Look at how you act when you are afraid you might lose something. If you can be counted on to follow through with a careful plan even when the going gets rough, then perhaps you have a high risk tolerance. But if you often panic, the chances are that your risk tolerance is relatively low.

The best tool we’ve ever devised for balancing a portfolio between bonds and equities is a table, which you’ll find here. In 11 columns, this shows you in detail what the results would have been for 30 years, from 1970 through 1999, of various combinations of bonds and equities. It also shows the same for the Standard & Poor’s 500 Index, as a reference point. The columns are arranged in increasing order of risk, with the safest listed on the left and the riskiest on the right.

When you study this table, your attention will probably gravitate to the bottom lines that show total return and various risk factors. That’s as good a place to start as any other, because those lines show the hypothetical results of each combination.

The way to use this table is to start by finding the column that has the results you want. For example, let’s say you feel quite conservative, and avoiding losses is a very high priority for you. Start by scanning the line that shows the worst 12 months, and find the column that has a 12-month return that you think you could live with.

For instance, you might find that the "(2.1)" figure is as high a loss as you want to accept, for planning purposes. This might seem pretty appealing, because there’s a big jump, up to a loss of 6.4 percent, when you take one more step up the risk ladder.

If 2.1 percent is the most you’re willing to give up in any 12-month period, that suggests you might be comfortable in a portfolio of 20 percent equities and 80 percent bonds. In the other lines toward the bottom of that column, you’ll find that that strategy produced a compound rate of return of 10 percent. So the next logical question is: Would a return of 10 percent get you where you want to go?

If a return of 10 percent is enough to meet your objectives, that’s a good sign that you’ve found a column that is right for you. In the years in this table, you would have had to endure a loss of 3.3 percent in a single month. If that’s too high, you have a problem, because even an all-bond portfolio, on the far left, had a higher worst-month loss.

To further check out whether this is the right combination for you, scan the annual returns from the top of the column to see how things would have unfolded year by year. You’ll see only one losing calendar year, 1994, and the loss that year was less than one percentage point. If everything you see in that column is within your comfort level, you have found the right combination.

More likely, you’ll find that there’s a disparity between your desired or needed annual return (on one line) and the worst 12 months you’d want to endure (on another line). That’s when all the numbers in this table are likely to be pretty helpful.

If the return you need (say 13.9 percent in a 70 percent equity portfolio) is only one column to the right of the loss you’re willing to accept (say 10.1 percent in a 60 percent equity portfolio), it’s not too hard to see your options. You could split the difference and use a 65 percent equity portfolio, knowing that you’re likely to be in the ballpark of the right risk and return for you. Or you could choose the lower-risk combination, in this case 60 percent equity, and accept a slightly lower return in order to stay within your risk tolerance.

The second of those two options would almost always be my choice. I’ve seen too many people invest beyond their risk tolerance, and the results can be quite counter-productive.

If the return you need is farther that one column away from the loss you can accept, then you should definitely gravitate toward the risk side of the gap. You can try to "stretch" your risk tolerance with positive thinking. But that’s not likely to work. If you’re like most people I know, when you have lost real money in your account, all your past thinking won’t be worth much. You’ll have an emotional reaction, and you’re likely to bail out of your investments at the wrong time.

It’s much easier to "stretch" your desire for return. I don’t want you to get in over your head because you are chasing after high returns that aren’t appropriate for you. I’d much rather put you in a position in which you have to work an extra year before you retire, or to cut your expectations for a retirement lifestyle, or to save a little more money now.

However, the choice is ultimately up to you, and this table gives you the tools you need to make that choice. Whatever combination of fixed income and bonds you choose, I strongly recommend the worldwide diversification we’ve outlined in this article for the equity part of your portfolio.

For most investors, a lifetime of investing can be divided into two stages, accumulation and distribution. You’re usually in one or the other.

In the accumulation stage, you’re letting your money grow for some future use. Whether or not you are regularly adding to your portfolio, the emphasis is on building for the future. Typically, employees are in this stage when they are saving for their retirement. In the distribution stage, you are withdrawing money regularly from a portfolio, typically in retirement.

During accumulation, your challenge as an investor is to achieve enough return (and to add enough assets if necessary) to reach your objective, while you keep your risk low enough that you won’t lose sleep over your investments or be tempted to bail out of your carefully devised strategy.

During the withdrawal phase of your investing life, you face the additional challenge of making sure you don’t run out of money and planning for increasing withdrawals to keep up with inflation.

A diversified buy-and-hold portfolio can be very suitable for either stage. Next month we’ll show you two different versions of these tables to illustrate how this portfolio can help you accumulate the assets you need – and how it can help you withdraw them so you never run out of money.