Use the right tools to diversify and you can even out the ups and downs of your portfolio. By Elizabeth Leary, Contributing Editor December 21, 2010 The stock-market cataclysm of 2008-09 didn't just wipe out $6 trillion worth of wealth in the U.S. It also destroyed many investors' faith in diversification. That's understandable. The conventional wisdom -- that a portfolio spread among stocks of large and small companies, growth- and value-focused strategies, and domestic and foreign firms would be well equipped to navigate a perilous market -- proved hopelessly misguided. A portfolio spread evenly among those categories would have lost about 57% over the market's full decline, from 2007 through 2009, comparable to the actual 55% drop in Standard & Poor's 500-stock index.But the failure of such wisdom lies not with diversification itself -- diversification, done properly, does work -- but with the outdated tools the conventional wisdom suggests you use to fashion a well-rounded portfolio. For diversification to improve returns, investors need to spread their money among assets that tend not to swing up or swing down in tandem with one another -- in other words, among assets with low correlations to one another. As recently as the early 2000s, dividing your money among companies of varying sizes in different sectors provided real benefits. For example, although the S&P 500 lost 47.4% during the 2000-02 bear market, shares of small, undervalued companies managed to produce a 1.6% gain, and the stocks of real estate investment trusts surged 36.6%. Not so in the recent bear market. Small, undervalued companies lost 59.6%. REITs shed 68.5%. Even the average non-government bond fund lost 3.2% (although the typical fund that focuses on U.S. government securities gained 9.2%). In other words, what counted as "well diversified" less than ten years ago doesn't cut it today. Advertisement One way to seek out investments that should hold up better in another rout is to pay attention to correlations. If the concept sounds abstract, consider the concrete benefits of holding investments that don't tend to move in sync with one another. A simple thought experiment illustrates the advantages: Suppose you held a portfolio of two assets -- Stock A and Bond B. Imagine that Stock A and Bond B have a perfect negative correlation with each other and are equally volatile. Further, imagine that Stock A will likely return 10% a year over the long haul and Bond B will likely earn 6% (albeit with plenty of volatility along the way). Thanks to their negative correlation, when Stock A returns more than 10%, Bond B will return less than 6%. And because of this relationship, the growth of a portfolio split evenly between the two assets would look like a straight, upward line -- your return would be an unwavering 8%. "You can build a portfolio that is more durable and that has a more stable path" by incorporating investments that don't move in lock step, says Carter Furr, who manages alternative-investment strategies at Signature, a Norfolk, Va., investment adviser. Moreover, with regular rebalancing -- which would force you to load up on Stock A when it lags and on Bond B when it underperforms -- your portfolio's returns could actually exceed 8%. These days, investors need to venture further afield than ever to find investments that march to their own drumbeats. Some of these asset classes may sound unfamiliar, but bear in mind that they are not necessarily any riskier than ordinary stock investments. A few are downright tame. On the following pages, we outline five options for your consideration. An allocation of 5% to 35% to these alternative assets could be appropriate, depending on your risk tolerance. Commodities WHAT THEY ARE: Investments in oil, precious metals, crops and other commodities have historically been good hedges against inflation. You can buy some commodities, such as gold, directly. For others, such as oil and gas, it is more practical either to invest in the stocks of commodity-producing companies or to track the commodities' prices with derivatives. OUR FAVORITES: Pimco CommodityRealReturn Strategy (PCRDX) is the best choice for investing in a broad package of commodities. Manager Mihir Worah uses derivatives to mimic the returns of the Dow Jones UBS Commodities index. But he can also make small side bets to try to beat its performance. Because the fund's derivative positions tie up only a small portion of its total assets, Worah invests the remaining cash in a portfolio of bonds. The fund has lost 2.2% annualized since Worah started managing it in early 2008, but that beat the index by four percentage points per year, on average (the fund lost 43.6% in 2008). Gold bugs should buy iShares Gold Trust (IAU), an exchange-traded fund that tracks the metal's price. Gold provides an excellent hedge against a falling dollar, which has inflationary implications. The fund has returned 24.6% annualized over the past five years (for more on gold, see Gold: Long-Term Hedge or Bubble About to Burst?). Advertisement BEST CHOICE FOR: Investors who are concerned about inflation but can handle some wild price swings. Long-short bond funds WHAT THEY ARE: This type of fund owns bonds the old-fashioned way but also sells certain bonds short. It shorts bonds using the same method for shorting stocks: by borrowing a bond from a broker and selling the security into the market, in hopes that the bond's price will fall so that the fund can repurchase it for a lower price. OUR FAVORITES: Driehaus Active Income (LCMAX) is the best choice for a tax-deferred account. Its managers take long and short positions in corporate and Treasury bonds, and aim to hold the portfolio's duration -- a measure of interest-rate sensitivity -- at zero. Its zero duration means that, unlike other bond funds, this fund shouldn't suffer if interest rates start to rise. It has returned 8.5% annualized over the past three years with less volatility than the average bond fund. For a taxable account, Forward Long/Short Credit Analysis (FLSRX) is a better choice. The fund's managers can take long and short positions in municipal bonds, corporate bonds and Treasuries, but they seek to generate more than half of the fund's income from tax-free munis. The fund has generated a 13% annualized total return since its May 2008 inception. However, it will likely be as volatile as the typical high-yield bond fund. Both funds have exhibited no correlation with the bond market as a whole. BEST CHOICE FOR: Investors who want exposure to bonds but are concerned about rising interest rates. Advertisement Long-short stock funds WHAT THEY ARE: In addition to owning stocks, these funds can sell short individual stocks or stock indexes to profit when stock prices fall. The manager of a long-short stock fund makes money primarily in two ways: by adjusting the ratio of short positions relative to a fund's "long" holdings (the more stock sold short, the less the fund will participate in the market's gains and the better it will do in falling markets) and by selecting wisely the specific stocks he purchases or shorts. OUR FAVORITE: John Hussman, of Hussman Strategic Growth (HSGFX), takes a guarded approach to money management. By selling short the S&P 500 and other indexes, he typically keeps his fund tightly insulated from the market's whims. This is a blessing in down markets but can be a burden in a rally; the fund lost just 6.5% during the 2007-09 down market but is up just 4.9% since. Hussman says he is cautious about stocks simply because he feels that they are too expensive and have been for some time. However, should stocks become cheap enough for his liking, Hussman has the flexibility to boost Strategic Growth's stock-market exposure by scrapping the fund's short positions. The fund has returned 7.4% annualized since its inception in 2000, compared with the S&P 500's annualized gain of 0.1%. BEST CHOICE FOR: Investors who are wary of the market but don't want to give up on stocks entirely. Managed futures WHAT THEY ARE: Most managed-futures investors rely on momentum strategies. In other words, they bet that investments that have been gaining will continue to rise. Because the managers invest with futures -- derivatives that let you bet on the future price of a given item -- they can place bets on a host of instruments and asset classes, including stocks, interest rates, commodity prices and currencies. And because traders can bet on prices rising or falling, they can make money in down markets as well as in up. Over the past 30 years, managed-futures investments have returned 11.6% annualized. Advertisement OUR FAVORITES: Rydex|SGI Managed Futures Strategy H (RYMFX) tracks a computer-driven index that is designed to mimic a common managed-futures approach. The fund has returned 1.6% annualized since its inception in early 2007, compared with the S&P 500's 1.2% annualized loss over the same period. The results include an impressive 18% gain over the course of the 2007-09 bear market. If you invest with an adviser who can give you access to load funds with their commissions waived, consider Altegris Managed Futures (MFTAX). This new fund invests with a group of top futures managers who may not be available to the average investor. BEST CHOICE FOR: Investors with a high risk tolerance, seeking high returns. Merger arbitrage WHAT IT IS: When acquiring another firm, a company normally pays a premium above the target's share price. The target's stock usually jumps on announcement of the deal, but not all the way to the purchase price. The shortfall reflects the risk that the deal could collapse or be renegotiated. Merger arbitrageurs buy a target's shares after a deal has been announced and hold until the merger is completed, seeking to capture the final few dollars (or cents) of appreciation between the post-announcement price and the deal price. If an acquiring company is paying for the target with its own shares, merger arbs may sell short the acquirer's stock, to hedge against a slide in the buyer's stock price. Merger arbitrage has historically been a relatively low-risk strategy. OUR FAVORITE: Roy Behren and Michael Shannon, co-managers of Merger Fund (MERFX), are old hands at this game. They say the biggest risk in such a strategy is that a deal will fall through, so their challenge is to invest only in deals that reach fruition. In general, about 90% of all announced deals are completed, compared with about 98% of the deals they choose to invest in. They invest in 45 to 65 pending deals at any given time. The fund has returned 6.4% annualized over the past 15 years, with one-fourth the volatility of stocks. It lost just 2.3% in 2008. BEST CHOICE FOR: Investors in search of steady, bond-like returns.