A sluggish economy combined with low interest rates makes things challenging for investors. Stocks aren't looking great -- they're down about 20% from their early October highs -- so many investors are wary of putting their money in equities. Yet, yields from fixed income investments remain low due to historically low interest rates.

Faced with this situation, many investors try to chase higher returns, either in the form of the latest hot stock pick, or higher yielding bonds. That's not always the best move, according to Greg Shultz, a principal at

Asset Allocation Advisors

, a financial planning firm located in California.

Instead, he says, the solution is to keep to a well-balanced, diversified portfolio -- meaning, one that includes an appropriate mix of both stocks and bonds. Bonds generate interest that will supplement your returns during a down market, and since bond prices are much less volatile than stock prices, bonds also keep your portfolio from plummeting if the stock market tanks.

"Truly great track records are not created in up markets, they're done in a down market," says Shultz. "By lowering your losses on a down market, you protect your capital and are better positioned to take advantage of a recovery."

Here's an example of how bonds can protect your assets during a stock market decline. The

S&P 500

fell 9.45% YTD during the first three months of this year. An asset allocation account from

Schwab

(SCHW) - Get Report

that

aimed for 80% stocks and 15% bonds (the remaining 5% was in cash) declined only 7.55% over the same period.

Meanwhile, a much more conservative fund aimed at retirees had 80% in bonds and cash and 20% in stocks; it fell 5.29%.

If your portfolio is properly diversified, keep up the good work. If you are like many investors, however, and are chasing higher yielding bonds or staying away from fixed income altogether, consider the following advice:

Decide How Much You Want in Bonds

What percentage of your portfolio you allocate to bonds should be a function of the amount of risk you can tolerate.

While stocks offer the potential for higher returns, they also carry greater risks. In the long term, however, the stock market tends to outperform bonds, so younger investors should have less of their portfolio in bonds (somewhere between 15% and 20%) to maximize the growth potential from stocks.

As you get closer to needing the money in your portfolio (say, for retirement or college tuition), the risk of losing too much in a market downturn becomes more significant.

Older investors should shift a bit more into bonds, without giving up the growth potential in stocks. Finding the right balance for you may require you to consult a qualified financial planner.

Diversify Your Bonds

Just because bonds are geared more toward stability than stocks doesn't mean you should ignore returns altogether. By keeping the bulk of your bond money in high-quality, intermediate-duration bonds you can satisfy the stability component of your portfolio. But by adding a dose of riskier high-yield bonds to your portfolio you can help improve your returns without exposing yourself to the potential for unacceptable losses.

Rebalance Periodically

Rebalancing to maintain the ratio of stocks to bonds that is right for you is an important component of managing your money. For example, when stock prices slump significantly, you may find that your allocation to stocks falls below your target.

By shifting money from cash and bonds into stocks you can restore that balance, while buying stocks at attractively low prices.

Peter McDougall is a freelance writer who lives in Freeport, Maine, with his wife and their dog.