TIMING IS EVERYTHING; DIVERSIFICATION STRATEGY CAN SMOOTH PORTFOLIO WHEN MARKET GETS ROCKY.

Byline: Deborah Adamson Staff Writer

Call it Wall Street's revenge.

In recent weeks, the stock market has turned in a stomach-churning performance worthy of Magic Mountain's Riddler's Revenge.

But unlike thrill-seeking teens, investors didn't relish the white-knuckled ride that brought havoc to their once ever-rising portfolios. In the past two weeks, Nasdaq had the wildest ride: Up 103, down 49, down 36, up 44 and so on.

``We're in a state of confusion right now,'' said Don Wellenreiter, commodity trading adviser for Defined Risk Asset Management in Newbury Park.

Indeed, the market can't make up its mind where to go.

Here's why: uncertainty over interest rates.

Higher interest rates are detrimental to stocks. Not only does it raise the cost of borrowing for corporations, thereby cutting into earnings, but higher rates also raises bond yields, increasing their attractiveness to investors.

Wall Street expects the Federal Reserve to raise interest rates, but until it meets June 29 and 30, no one knows how high the rates will go and whether there will be several increases.

Why raise rates? To combat inflation. As the nation's central bank, the Fed has the power to raise key short-term rates to shrink the money supply and slow down inflation.

``The true enemy of the financial markets is inflation,'' said Geordie Crossan, co-owner of NBS Financial Services, a fee-only investment advisory firm in Westlake Village.

Inflation means a rise in prices. Low and moderate inflation is good for businesses because they can raise prices. But high inflation, as seen in the late 1970s, is damaging to corporate earnings as prices spiral ever higher. By raising interest rates, the Fed would control inflation. Both Fed Chairman Alan Greenspan and his predecessor Paul Volcker have been inflation hawks.

The market is queasy because investors don't know how the Fed will act. If there are several rate increases, such as in 1994, the market will be in for a major downturn. But there are hints this won't be the case. Rather, the market is leaning toward a rather short and shallow correction: Last week's consumer price report for May came in as expected, giving investors a sense of relief that the Fed won't be as pressured to raise rates steeply.

In the meantime, investors are hanging on for dear life. If you're like many investors, you might feel like jumping off - sell and put everything in cash.

But before you panic, financial planners say you should draw up a plan.

Investors without a plan of action are playing the difficult game of market timing - trying to sell at a market top and buy at a bottom.

Most folks can't do it. By the time a top is obvious, it may be too late. Investors who sit out a down market and hope to jump in later as soon as an upturn is apparent risk staying out of a rally. When the market turns, it turns quickly, financial planners say.

A better way to temper volatility is to put your eggs in many baskets.

``Diversifying is a better way to handle risk,'' Crossan said.

Diversification or asset allocation means to spread one's money among several types of investments. The rationale behind it is to have a counterbalancing system. When one type of investment goes down, another would go up. A diversified portfolio could include growth, value and sector U.S. stocks, foreign stocks and various types of bonds. Thus, the investor is sheltered from severe drops from overexposure in one area.

But it also means that when a particular type of investment is doing well, a properly allocated portfolio won't get the maximum gains as well.

However, asset allocation has long been a mantra among financial planners because of market cycles. In any one period of time, certain industries or sectors will do well and the diversified portfolio always participates in some way. In the long run, the hope is that diversification provides better overall returns.

In the past two years, an interesting thing has happened. As growth stocks - especially in the technology and Internet sector - have gained favor, the properly allocated investors have had to take market-lagging returns.

Tired to seeing lackluster results while the market surges higher, they've been shifting toward growth stocks, Crossan said.

But as these securities became more expensive and threats of inflation loomed in recent weeks, they got hit badly.

``You're shaking out stocks that got excessive(ly overpriced),'' said Gil Morales, a portfolio manager at William O'Neil & Co. in Los Angeles.

Indeed, the long-languishing small and mid-cap stocks have begun to pick up as the market cycle swung in their favor again - benefiting those who stayed properly diversified.

``When they start writing articles like `Is Asset Allocation Dead?' you know (a cycle shift) is going to happen,'' Crossan said.

So make sure your portfolio is diversified, experts say. Crossan recommends about 55 percent to 60 percent in equities and the rest in fixed-income securities and cash.

If growth stocks are taking up a much larger percentage of your portfolio than you want, sell some to bring the proportion in line with a diversified plan.

As for investors who want to play the market more aggressively, one plan is to keep 60 percent of their assets in a traditional allocation that doesn't try to catch the current fad on Wall Street. The remaining 40 percent would capitalize on present trends, said Laura Tarbox, a Newport Beach financial planner named by Worth magazine as one of the top 300 in the country.

For 60 percent of the portfolio, she recommends that 27 percent be kept in large-cap U.S. stocks, 9 percent in midcaps, 9 percent in small-caps, 9 percent in foreign stocks, and 6 percent in fixed-income securities and cash.

For the 40 percent, she advises an overweight of selected large-cap stocks in technology, health care and retail.

However, investors who will need the money within three years should park it in more stable investments such as a money market fund, Tarbox said.

Another strategy is to use riskier and more complex investments such as put options, but only if the investor is experienced in it, Wellenreiter said.

A put option gives an investor the right to sell shares at a predetermined price within a period of time. The rationale is to ``lock in'' a selling price just in case his or her stocks drop. But if investors don't exercise that right, the option will expire - taking their money with it.

Savvy investors may also opt to short sell. In a short sale, an investor borrows shares from the broker and sells them in the market. If the stock drops, the investor can buy the stock at a lower price and give them back to the broker. The investor pockets the difference.

What about buying stocks now while the prices are knocked down?

It's not advisable to bottom-fish right now since the market hasn't made up its mind about which way it wants to go, Morales said. The danger is that it's not clear whether the market has hit bottom; it could go lower.

``The intermediate correction could continue for a few weeks or months with the possibility of a bear market - but it's not clear yet,'' he said.

However, while Morales believes a bear market is possible he believes it's not likely because the U.S. economy continues to be strong and the global economy is improving.

SOME OPTIONS

Looking for a few good places to park your money besides the stock market?

If you're tired of market volatility or you've cashed in your profits from Internet stocks and wish to shelter your money in more stable investments, here are a few thoughts from financial planners and market analysts about the pros and cons of some popular alternatives.

TREASURIES: Opt for Treasury bills or intermediate-term notes instead of bonds. These are all government-issued debt, but with varying maturities. While there are exceptions, in general bills span one year or less, notes mature after one year up to five years and bonds have longer time frames.

The longer the maturity, the more sensitive the Treasury is to interest rates. Since the interest rate picture isn't clear yet, stick with shorter terms.

UTILITIES: Not a good idea right now. They're interest-rate sensitive. With the Fed hinting at higher rates, utilities will get hurt. Why? Utilities and bonds tend to attract the same type of investor and hence they compete for the same pool of money. When interest rates rise, bond yields go up because they have to be competitive with new bonds coming to the market. A higher bond yield bodes ill for utilities - investors might shift their money there.

GOLD: Don't go there. Gold prices have been depressed for a long time, and there could be additional weakness coming soon as the International Monetary Fund and the British sell some of their gold, said Don Wellenreiter of Defined Risk Asset Management in Newbury Park. Besides, gold, long considered an inflation hedge, has been replaced by the U.S. dollar as a safe haven during downturns, said Geordie Crossan of NBS Financial Services in Westlake Village.

PREFERRED STOCKS: These are a hybrid of stocks and bonds. They don't move as much as common stocks, but they pay a good dividend. Laura Tarbox, a financial planner in Newport Beach, says to look for preferreds that pay a 7 percent or 8 percent yield.

CONVERTIBLE BONDS: These are corporate bonds, or debt, that can convert into stocks. Again, look for yields of 7 percent to 8 percent, according to Tarbox. She likes Fidelity Convertible Securities and Davis Convertible Securities funds.

REITs: Financial planners are lukewarm on real estate investment trusts. Investors who buy REITs are purchasing securities of a company that invests in real estate. But unlike other companies, REITs distribute most of their profits to investors. While REITs are a good value now, they're still languishing. Also, they get hurt when interest rates go up since they compete with utilities and bonds for investors' money.

HIGH-YIELD BONDS: These are debt of corporations that don't enjoy the highest credit ratings. As a result, they'll pay a higher yield to attract investors. Crossan recommends picking only companies with top ratings such as B or BB.

401(K) GIC: Most company retirement plans have a guaranteed investment contract option. While they don't fluctuate like stocks, this investment isn't 100 percent safe either despite its name, said Steve Merrill, president of the National Association of 401(k) Investors in Melbourne, Fla.

When investors buy a GIC, they are handing over their money to the insurance company and receive a guaranteed rate of return, such as 5 percent. Investors don't have control of how the insurer is investing the money.

If an insurer loses money on an investment that has a guaranteed rate of return, the shortfall would have to come out of the company's pockets. When losses are huge, the company may go under. In a GIC, investors trade market risk for credit risk - your money is only as safe as the company.

However, such insurance failures are rare, Crossan said. The state also fully or partially reimburses investors who lose money in such cases.

ANNUITIES: A lot of seniors are sold annuities, and it's not a good deal, Crossan said. An annuity, like the GIC, is an insurance product. In a fixed annuity, the investor hands over money to an insurer and receives a guaranteed rate of return. The insurer invests the money for the investor and charges fees for the service.

In a variable annuity, investors decide how to invest their money. The guarantee investors get is safety of the principal when they die. But the risk of an annuity being less valuable at the investor's death is small and doesn't justify the higher fees, Tarbox said.

Crossan pointed out another pitfall: Annuity profits are taxed as income, not capital gains. Long-term capital gains are capped at 20 percent. But if it's taxed as income, investors could pay much higher taxes on the annuity profits depending on their tax bracket.

MONEY MARKET FUND: If you want your money in a liquid fund, money markets are the best option. Because it invests in short-term debt such as Treasury bills, commercial paper and the like, it's stable and not sensitive to rate swings.

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