Scott and Heather Connell won't retire for three decades. But the Delray Beach, Fla., couple are already preparing for life after work. They contribute the maximum to their 401(k) plans and sock away money in taxable accounts. "My father instilled in me the importance of saving and investing," says Scott, 30. "It’s vital. Everyone wants to retire, but so many people never map out how to get there. We’re starting young because we want to make sure we have enough to live well."

So how do you assemble and maintain a mutual fund portfolio? We’ve distilled the task into eight rules.

1. Don’t chase winners

Suppose you had decided on the first day of 2000 to invest $10,000 in each of the five best-performing funds of the preceding five years. The idea would have been tempting -- on average, the fabulous five funds had earned an annualized 53%. But the next five years told a different story. Those same funds lost 61% of their asset value. In other words, your $50,000 investment would have shrunk to $19,695.

Past performance does matter. But in a vacuum, chasing winners is as dangerous as day trading. Not surprisingly, all five of the top-performing funds at the end of 1999 were technology sector funds. And sector funds belong at the edges of a portfolio, not at its heart.

2. Spread your risk

"In ancient times, when the crops were harvested, they shipped them in many different boats," says Jim Reardon, a financial planner in Topeka, Kan. By the same token, to build a solid investment plan, you need to diversify.

Roughly half of the money you have targeted for stocks belongs in funds that specialize in large companies -- those that are household names. Among large companies, half of the money should be in a fund specializing in growth stocks -- those with fast-growing earnings -- and half in a fund that buys undervalued stocks that are currently out of favor. Technology firms exemplify growth stocks, and financial and industrial companies epitomize undervalued stocks.

Put a quarter of your stock money into a foreign fund, preferably one that invests some of its assets in emerging markets, such as China. Although half of the world's stock market value is outside the U.S., most people don't invest enough money abroad. European stocks are cheaper than U.S. stocks, and Asian companies are growing faster. What's more, foreign stocks have beaten U.S. stocks for four straight years.

Invest the last quarter of your stock money in a fund (or funds) that specializes in stocks of small companies. This lets you take advantage of their higher growth rate. Over the long haul, small-company stocks have returned about two percentage points more per year than their larger brethren. For optimal diversification, you'll want two small-company funds -- one that buys growth stocks and another that buys value stocks -- or one fund that buys both.

3. Learn how funds differ

When you pick your funds, be sure to rate them against other funds that fish in the same waters. Don't expect a value fund and a growth fund to have similar track records. Only by comparing funds with their true peers will you make superior choices.

Why bother with all different kinds of funds? Because they don’t move in lock step the way those ill-fated technology sector funds did. When stocks of small companies are humming, large companies often languish. Growth stocks and value stocks also counterbalance each other, as do U.S. and foreign stocks. Case in point: The average fund that invests in stocks of large, fast-growing companies has lost money during the past five years. Over those same five years, funds investing in undervalued stocks of small companies have returned an annualized 14%, on average.

Will the same types of funds prevail the next five years? History suggests not. Like a pendulum, the market eventually swings back the way it came. Owning a mix of funds smoothes out the ups and downs in your investments -- without sacrificing one iota of return.

You can profit from the pendulum swings. Here's how: At the end of each year, tote up how much you have in each kind of fund. Target new money to the funds that have done poorly. Better yet, rebalance your portfolio by selling some of the winning funds and putting the proceeds into the laggards, so each fund ends up with the same percentage of money it started with the year before. Rebalancing takes guts -- it's hard to reward losers -- but it works.

4. Steady your nerves

Stocks often bounce around like a roomful of toddlers. It's no wonder many people grow leery of them. But investing too little in stocks is a mistake. Over the long haul, stocks' volatility levels off. Indeed, they have been the surest route to wealth for more than a century.

Stocks behave erratically over the short term -- no question. In their worst year since 1926, stocks plunged 43%; in their best, they gained 54%. But look at the calming effects of time. Over rolling ten-year periods (such as 1930–39, 1931–40 and so on), including the Great Depression, stocks have never lost more than an annualized 1%.

The more you know about stocks, the more comfortable you'll become with them. Over five-year periods, stocks have made money 90% of the time, as measured by Standard & Poor’s 500-stock index. And they have beaten bonds and cash (money-markets, CDs and Treasury bills) in about 80% of five-year periods. Over 20-year periods, stocks have never lost money. And they have always earned more than bonds and cash. Stocks have returned more than an annualized 10% since 1926. That compares with 5% for bonds and 3% for cash, according to research firm Ibbotson Associates.

Inflation, moreover, wreaks havoc with "safe" investments, such as bonds and cash. With inflation averaging 3% since 1926, your real, after-inflation return drops to a puny 2% from bonds and zero from cash. But stocks have returned an annualized 7% after inflation. (At 2%, it takes 36 years for your money to double. At 7%, it will double in just over ten years.) Because of stocks' superior returns, long-term investors should put as much as they can stand in stock funds -- and hang on.

That's easier said than done. "Most investors have a real time horizon of 20 years or more but an emotional time horizon of about 30 seconds," says Harold Evensky, a financial planner in Coral Gables, Fla. But here's the silver lining: If you lived through the 2000–02 bear market, in which the S&P 500 lost 47% of its value, you've taken and passed a real-life risk-tolerance test. You have a terrific idea of what you're likely to do the next time the market heads south.

You may well do better. Most bear markets inflict less pain than the last one. On average, stocks lose 30% of their value in a bear market -- and bear markets occur about once every five years. As you become a more experienced investor, you usually learn to endure short-term reverses better.

But no matter what the numbers tell you, don't put more money into stocks and stock funds than you can handle. You need to be able to sustain a temporary loss of 30% or more without bailing out at the bottom.

MORE: Kiplinger.com | Investing | Mutual Funds

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