Investing: Feeling snakebit? Try a conservative portfolio

— -- This year's stock market has probably made you long for a safer investment, like a cobra farm.

Before you start raising reptiles, however, you might consider constructing a sturdy portfolio of extremely diverse investments. You'll just have to fight the desire to ditch the portfolio once there's a new bull market — and that's harder than herding snakes.

The average stock mutual fund has lost 3.6% through Wednesday, tacking on one more miserable year to the 21st century's wretched record.

But most investors probably did better than the average stock fund this year. The fund industry started 2010 with 47% of its assets in stock funds, according to the Investment Company Institute, the funds' trade group. Another 22% was in bond funds, and 24% was in money funds.

Money funds yielded slightly more than a flea's toenail this year, but bond funds boomed. The average U.S. government securities fund gained 8.9%.

A portfolio with 50% in stocks, 25% in bonds and 25% in money funds — roughly the industry average — would have eked out a 0.4% gain. Nothing great, but not a loss.

Not all diversification is helpful. Adding international funds to your portfolio would have worsened your performance, thanks to all the woes in the eurozone. And high-yield, low-quality junk bonds gained just 2.5% as investors fled anything with the risk of default.

The main problem with international funds and junk, however, is that they are too closely correlated with the investments you want to diversify away from. Foreign stocks tend to swoon at the same time as U.S. stocks. And junk bonds track stocks more closely than bonds do.

Let's say, however, that you want to create a portfolio that will have some elements that will prosper under any given economic circumstances. For the good times, you want stocks. But you want other investments to protect you in bad times.

Investors should worry about two things: deflation and inflation. Deflation is a period of economic contraction accompanied by falling prices. The last big outbreak of deflation was the Great Depression, although the past three years have had many of the hallmarks of a deflationary period. (Yes, gas and food prices are up. But many of your biggest assets, from your house to your 401k, are down dramatically.)

Typically, high-quality bonds, such as Treasury securities, do best in a deflationary period. Bonds make regular income payments — and when prices are falling, those payments become more valuable each month. High-quality dividend-paying stocks also do well in deflationary periods.

During inflationary periods — a time of rapidly rising prices — gold, natural resources and real estate often do well. People prize tangible investments when paper money loses its value.

In theory, you could construct a sturdy portfolio with 25% positions in stocks, gold, Treasury bonds and money funds. You wouldn't get rich. But you wouldn't suffer mind-melting plunges, either.

The venerable Permanent Portfolio (ticker: PRPFX) has used a variant of this strategy since 1982. The fund has 20% of its assets in gold, 5% in silver, 10% in Swiss francs, 15% in global natural resource and real estate stocks, 15% in aggressive growth stocks, and 35% in Treasury securities.

The fund has gained an average 10.9% a year, according to Morningstar, the mutual fund trackers. Its assets have swollen to $15.8 billion. Not surprisingly, the fund's performance has slowed: It's up just 1.5% this year.

You might also consider a conservative asset allocation fund. Back in the day — 2000 or so — these were called "balanced funds." Typically, these funds are a mix of dividend-paying stocks and bonds, with the emphasis on bonds. Vanguard Wellesley Income, for example, is about 35% stocks with 61% in bonds and the rest in cash.

Other conservative asset-allocation funds, such as API Efficient Frontier Income, venture farther afield. But the idea is the same: modest gains, modest losses. Sound good? Of course.

But be warned: Sooner or later, we'll have another rip-snorting bull market, and you'll feel like a clod with your conservative portfolio. If you keep jumping from one portfolio to another, you'll just wind up with a snakebit portfolio.

John Waggoner is a personal finance columnist for USA TODAY. His Investing column appears Fridays. See an index of Waggoner's columns. His book, Bailout: What the Rescue of Bear Stearns and the Credit Crisis Mean for Your Investments, is available through John Wiley & Sons. John's e-mail is jwaggoner@usatoday.com. On Twitter: www.twitter.com/johnwaggoner.