WHERE to put your money.

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Author: Kiplinger, Knight

MY POINT OF VIEW

INVESTORS looking to park some fresh savings or move their money around are faced with seemingly unappetizing choices among the major classes of assets--stocks, bonds and real estate. Why?

Because nothing is a screaming bargain--not like real estate in the mid 1990s after the late-'80s bubble burst. Or bonds in 2001 before the long slide in interest rates. Or stocks in the autumn of 2002, when the Dow bottomed at 7286 after a brutal plunge from 11,723 in early 2000.

Pricey property. Today, residential real estate is severely overpriced in most large metro areas. Prices will likely flatten or decline as mortgage rates gradually rise, rents fall amid a surfeit of investor-owned houses and condos, and the affordability chasm widens between home prices and personal income.

If you've done well investing in residential property, congratulations. But don't count on similar gains over the next few years. And if you missed the gravy train, don't chase it down the track, waving fistfuls of money for an overpriced condo in South Florida or Washington, D.C.

Real estate investment trusts (REITs)--mutual funds that own office buildings, shopping centers and apartments---are likely to feel a downdraft on both their prices and the rents they pass through to shareholders as dividends.

The result: A lot of the capital that fled the stock market for the haven of real estate over the past five years will start looking for a new home.

Will it move into bonds? Maybe, but it shouldn't because rising interest rates will continue to depress the price of bonds issued at lower rates. On a total-return basis, bonds probably won't look very enticing again until sometime late in 2006, when yields plateau at about a percentage point and a half higher than today.

If you've sensed by now that I'm leaning toward stocks--if only by default--you're right. Not that stocks are without risk, mind you. Although the year-over-year profits of the 500 big companies in Standard & Poor's index have averaged double-digit increases for 13 consecutive quarters, earnings gains are likely to slow down. That's because consumer spending will lose some steam after the spike in fuel prices following Hurricane Katrina. Businesses, too, will be burdened by the same higher energy costs, as well as rising costs for health care, labor and borrowing.

Nonetheless, large companies are still likely to increase their earnings 8% or 9% a year, with many small and midsize companies growing faster. Historically, stock prices have advanced roughly in line with corporate profits over long periods.

Further buttressing the case for stocks is the fact that American businesses are carrying very little debt, so rising interest rates won't hurt their bottom line much. To the contrary, firms are flush with cash--an enormous trove of retained earnings that can be used to expand internally, acquire other companies, buy back their own shares and pay higher dividends to their shareholders.

As for stock valuation--that is, the multiple of corporate profits that investors are willing to pay for a share of stocks Standard & Poor's 500-stock index sells for about 17 times estimated 2005 earnings. That is not dirt-cheap, but it is much more attractive than the high-20s multiples of 1999.

So I see relatively less risk, and a greater opportunity for gain, in the stock market than in bonds or real estate for the next year or two.

The risks. Now, this isn't a clarion call to place big bets on stocks, because a lot could go wrong with the scenario I've described. The drag of high energy prices and other dislocations from the Gulf Coast disaster could slow economic growth to a crawl or, even worse, push the U.S. into recession. That would batter stocks and real estate. But bond prices would firm up, because if things went really awry, the Federal Reserve Board would suspend its steady march to higher interest rates and might even cut them.

In my opinion, recession is not in the cards. Slower growth, yes. but not a contraction. The Fed is as concerned about inflationary pressures--from high energy prices and The increasing federal budget deficit--as it is about the risk of an economic slump. So even if there is a pause in its rate hikes, it won't last long.

With tomorrow's investment climate even more uncertain than normal, and with no asset class truly bargain-priced, this isn't the time to put all your chips in one place. But neither should you simply give up and stuff all your money under the mattress.

Scatter your bets. Now more than ever, you need to own all the major asset classes, in fixed proportions appropriate to your age, wealth, tolerance for risk and need for liquidity. This is called asset allocation, and its rigorous discipline--the rebalancing of your portfolio every six months or annually--will force you to do what is hardest for most investors: Sell high, buy low.

Say, for example, you decided in the late 1990s to limit stocks to 60% of your financial assets, with 25% in bonds, 10% in REITs and 5% in cash. As stocks soared in '98 and '99, they might have hogged 80% or more of your portfolio's value. Rebalancing to your original proportions would have led you to sell stocks automatically back down to 60% and load up on bonds and REITs--asset classes that were out of favor and relatively cheap.

Together, asset allocation and rebalancing would have saved you a lot of grief and money in the bear market that slammed stocks during 2000-02. And the same discipline--this time forcing you to sell bonds and real estate and load up on stocks--will serve you well in the investment climate ahead.

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By Knight Kiplinger

Columnist Knight Kiplinger is editor in chief of this magazine and of The Kiplinger Letter and Kiplinger.com.