Always Think About That Portfolio Mix By Brian Reynolds Special to TheStreet.com 5/15/01 9:07 AM ET

It feels as if I've stepped on a hornet's nest these past two weeks, first with my analysis of the economy and then with my analysis of the poll of readers about the economy. I've received a ton of feedback, some saying that I'm way too optimistic in thinking that the economy will muddle along and some saying I'm way too pessimistic for not expecting an acceleration.

It looks like we have a real battleground of opinion, and I believe that it is a good idea to look at some common-sense ways to position yourself depending on risk tolerance and outlook. What struck me is how passionately each camp feels about its position. I received some well thought-out responses stating how the economy has to get worse following the popping of one of the biggest bubbles in history, and I heard from a number of people who believe the Fed has been easing too aggressively, which will lead the economy and inflation higher.

Both camps need to recognize that each can't be right. Each side should be aware that there are people with wildly different opinions. The trick is to set up a portfolio that incorporates your opinion while allowing you to make some money and stay in the game.

Many advisers recommend setting a target weight for stocks, bonds and cash based on your financial situation and goals. That's a good idea, and I know many successful investors who just rebalance their portfolio when it strays from their target, and only adjust their optimal weighting slowly as their financial situation evolves.

Want to be more aggressive? Consider using a method I've used successfully over the years. Instead of using fixed targets, set up a range around those targets. This involves figuring out what your maximum and minimum weightings for each asset class would be if you felt very strongly or negatively toward these classes.

This strategy has a number of advantages. Thinking about what your maximum and minimum exposure to a sector should be allows you to figure how much risk is too much, as well as how much risk is too little.

Using ranges can provide a framework for implementing ideas and can prevent you from going overboard. It can help you make tough choices, and it forces you to think about just how much you love or hate a particular sector.

I'll use my own situation to demonstrate this process. Keep in mind that my weightings work for me in my financial situation. They will not be right for everyone; I'm just using them to illustrate concepts.

I've come up with a range of 30% to 50% for bonds, 30% to 60% for stocks and 15% to 40% for cash. The first thing that many readers will notice is that the maximums add up to well over 100%. That's by design; it forces me to make choices.

If I were to think that bonds offered an extraordinary value and if I were at a minimum of 15% in cash, then I would have to bring my equity weighting down to 35%. Before I did that, I'd have to reassess just how much I liked bonds and figure out if it would really be worth bringing my equity position down to such a low level.

Currently, I'm at a 35% bond weighting, up from the 30% that I had a few months ago. That means that I didn't see great values in bonds a few months ago but am starting to like them more as yields go up.

I continue to hear from many of my bond brethren who believe the Fed has been too aggressive, making it likely that the economy will snap back. At the low levels of a few months ago, I thought bonds didn't provide enough compensation against the possibility of a stronger economy to warrant an overweighting.

Now that bond managers are acting on their fears of a stronger economy by pushing yields up, I believe that a booming economy is less likely. This makes bonds more intriguing, and I've been slowly adding to my position. I don't see much evidence of the economy snapping back to life, and as long as that continues, I think bonds will become more attractive the higher their yields go.

You can make your ranges as broad or as narrow as you wish. I like to have ranges for different bond sectors as well.

For example, I have a range for long Treasuries of 0%-20%. I was at 0% to start the year, because I thought the inverted yield curve fully expressed a weak economy. As the Treasury curve steepened in the past few months, I've moved up to an 8% weighting, not quite to the midpoint of my range. Not coincidentally, the curve is also near the midpoint of its range.

Ten-Year Less Two-Year Treasury Spread in Basis Points As the curve steepens, longer bonds begin to reflect fears of a stronger economy

I'm in a position to buy more, but only if the curve steepens further. I've shifted from shorter maturities, which have done well, to longer ones as the yield differential has increased. If I were to buy more longer Treasuries, the money would have to come from somewhere else.

In that case, I would most likely sell corporate bonds to go into long Treasuries. Corporates have done very well this year, as I expected. In fact, the yield curves of corporate bonds have flattened this year even as the Treasury curve has steepened. That means that long corporate bond spreads are near their narrowest in a year.

Spreads are still wide when viewed from a historical perspective, so I'm sticking with corporates for now. If Treasury yields continue to rise while corporates are stable, though, I will lighten up on corporate exposure in favor of Treasuries.

A reason why I like corporates is that investors still have an appetite for selected corporate debt. As was the case in December, WorldCom's (WCOM:Nasdaq - news - boards) ability last week to price a large bond deal illustrates that investors are willing to fund companies that have a good chance of being able to repay their debts.

Companies without these prospects remain shut out of the financing arena, and I believe this will help separate the winners from the losers. One of the pleasing aspects of the WorldCom deal was the company's intention of using some of the proceeds to reduce its reliance on the commercial paper market. This makes WorldCom less subject to rumors of liquidity problems like Motorola (MOT:NYSE - news - boards) had to deal with last month.

I've also written that while the economy may not bounce back, that doesn't mean the stock market can't advance as cash becomes less attractive. In that vein, I've also increased my stock holdings (in deference to the bear case, I'm being very disciplined with my stops and in trying to find inexpensive puts to limit my risk) at the expense of cash.

All this provides me with a good diversification between stocks, bonds and cash. It provides me with the ability to implement my views without exposing me to too much risk in any one area. More importantly, this process forces me to constantly re-evaluate and assess my thinking.

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