Year-end investment strategies: the end of the year could be the beginning of great portfolio returns.

MARKED BY SOARING OIL PRICES AND surging floodwaters, 2005 has been a difficult year for investors. Generally, the larger U.S. stock and bond markets have gone nowhere. Foreign markets, though, have had a decent year while some areas of real estate continue to boom. Looking back on such hit-or-miss results, what can investors expect from 2006?

Domestic stocks. "Since 1926, an investor who bought stocks in the Standard & Poor's 500 Index has ended up ahead of inflation, over every 20-year period," says John Eckel, president of Simsbury, Connecticut-based Pinnacle Investment Management. "That stretch of time included the stunning stock market decline during the Great Depression of the 1930s as well as the major bear markets of 1973 to 1974 and 2000 to 2002."

Stocks have delivered for patient long-term investors such as Deaidra and Curtis Wilson, both 42, of Carrollton, Georgia. "I've been investing regularly for more than 20 years," says Deaidra, a high school assistant principal, "and I will continue to do so, as we prepare for our own retirement and our daughter's education."

Curtis is putting most of his available cash into his business of supplying vehicles for corporate events, so Deaidra is handling a great deal of the family's investing, inside as well as outside of her school's retirement plan. "About 80% of our investments are in stocks and stock funds," she says. "We have time to be fairly aggressive in our investing, to ride out any short-term problems."

Fred O'Neal, an investment representative with Edward Jones Investments in Carrollton, who advises the Wilsons, agrees that a portfolio oriented toward equities is appropriate for this couple. "When investors have 20-plus years until retirement," he says, "they should be growth-oriented, and that generally means emphasizing equities."

Among individual stocks, the Wilsons favor large, familiar companies such as Hershey and Wal-Mart. "We know them," says Curtis, "and they seem to be well-managed." Such companies can be expected to remain in business and earn profits.

"Those are good companies with good brands," says O'Neal. "Looking ahead to next year, I'd suggest that the Wilsons add to their equity positions. They probably should spread their risk by going into other sectors. Now they're in consumer staples so they might diversify into energy stocks such as ExxonMobil and financial services companies such as Wells Fargo."

The Wilson's mutual fund selections include American Funds Fundamental Investors, which seeks undervalued stocks, and Lord Abbett Alpha Strategy. The latter--a fund of funds--holds small-company and international funds from the Lord Abbett family, further diversifying the Wilson's portfolio.

"For now, U.S. stocks seem to be reasonably valued in light of earnings and interest rates," says Eckel. "However, my expectations are for modest returns as a result of rising interest rates and rising energy prices, which provide a drag on the economy and may be a source of inflation." Therefore, while investors should have some money in U.S. stocks in 2006, other types of investments should be included to dampen the risk and add to potential profits.

Foreign stocks. At the beginning of 2005, virtually all the experts predicted the U.S. dollar would fall, which would benefit investors in international stocks. For example, if a European company has earnings in euros, and the euro gains against the dollar, a U.S. investor who has stock in such companies will see his or her profits go up along with the euro.

Instead, the dollar gained ground throughout 2005, which should have depressed foreign stock returns for U.S. investors. Despite the dollar's strength, though, international investing paid off in 2005 as virtually every foreign market posted gains. At press time, for example, the Dow Jones indices for France, Japan, and the United Kingdom were each up 6.75%, 8.68%, and 3.89%, respectively, for the year. Emerging markets such as Brazil and Mexico were up 42% and 23.39% in 2005.

Should you move some of your dollars overseas in 2006? Many financial professionals would answer positively. "You can't achieve real diversification without including foreign investments," says Tom Henske, a partner at Lenox Advisors in New York. "Currently, international equities are trading at a discount relative to U.S. stocks. Historically these stocks trade at a premium relative to the U.S." Not only are foreign stocks a bargain these days compared with U.S. issues, but Henske expects the dollar to level off next year. So currency should be neutral for international investors, not the negative factor it was in 2005.

"We think most investors should have 10% to 20% of their equities in international investments," says O'Neal. "There are a lot of top companies outside the U.S. Often the best way for investors to get access to foreign investments is through mutual funds."

There are literally thousands of funds to choose among if you want to add an international ingredient to your portfolio. John LeBlanc, principal and co-founder of Back Bay Financial Group Inc. in Boston, says Julius Baer International Equity Fund is promising. "In addition to Western Europe, where many funds invest, this fund has a great deal of expertise in fast-growing central Europe," he says. LeBlanc also favors funds that invest in smaller foreign companies, such as Forward International Small Companies Fund.

Bonds. The Federal Reserve continued to raise short-term interest rates throughout 2005 and there is no sign it will cease this tighter-money policy anytime soon. Eventually, long-term rates may head north, too, which would be bad news for bondholders because rising interest rates devalue existing bonds and bond funds.

"We're at the end of a 25-year bull market in bonds," says Timothy Chase, principal of WMS Partners, a financial planning firm in Towson, Maryland. "We're telling investors not to invest in long-term corporate and Treasury bonds because that's where the interest-rate risk is the greatest."

Some strategies may allow you to survive in this environment. "Bond investors can ladder maturities to reduce interest-rate risk," says O'Neal. That is, investors might hold some bonds maturing in 2006, some in 2007, some in 2008, etc. When each bond comes due, the proceeds can be used, if cash is needed, or reinvested in a longer-term bond. Therefore, if interest rates rise, which would devalue bond holdings, investors can keep reinvesting at higher yields.

"Investors who truly are in for the long-term might extend their ladders out to 20 years," says O'Neal. "Bond laddering usually makes sense if you have at least $50,000 to invest in bonds. Investors with smaller portfolios can invest through bond funds. In today's environment, it makes sense for most people to invest in tax-exempt municipal bonds and municipal bond funds because tax-exempt yields are nearly as high as the yields on taxable bonds."

Another type of ladder might be useful for Ann and Darryl Heggans of Chicago, now that Darryl, 38, has just started his own advertising sales rep company. "Cash flow will be very important for Darryl, with his new business," says Aubrey Lee Jr., a vice president, wealth management adviser, and PIA portfolio manager with Merrill Lynch in Dearborn, Michigan. "Not only should they have six months' income in cash reserves, such as a money market fund, so they can pay their bills, they also may want to become more conservative in their investing by moving some assets from equities to fixed-income. They might consider laddering insured certificates of deposit, maturing, say, in three months, six months, nine months."

Even investors without a need for ready cash may want to emphasize short-term bonds, bond funds, and CDs these days, says Lee. "Short-term rates are almost as high as long-term rates now," he says. "Investors aren't being rewarded for taking on the risks of long-term bonds." For example, two-year Treasuries recently were yielding 3.97% while 10-year Treasuries were paying just 4.27%.

What other fixed-income strategies make sense now? "We are buying Treasury Inflation Protected Securities (TIPS) as a part of most clients' fixed-income portfolios," says Bill Brennan, principal of Capital Management Group in Washington, D.C. TIPS are government bonds that offer a fixed rate of interest on their principal. That principal, meanwhile, is adjusted every six months for changes in inflation.

"If inflation goes up," says Brennan, "the bond principal goes up and the semiannual interest payment goes up. However, a decrease in the consumer price index cannot cause the bond principal to fall below face value, guaranteeing a minimum rate of return."

The combination of inflation hedge, diversification value, and potentially higher fixed-income returns makes TIPS a good fit for many individuals, says Brennan. "We are currently using the iShares Lehman TIPS Bond Fund, with an expense ratio of just 0.2%, as our preferred investment in this category," he says.

Chase suggests investors use some unfamiliar energy investments as income-producing vehicles. "There's a lot of evidence to suggest that higher prices for oil, and especially for natural gas, are a long-term mega trend," he says. High energy prices can generate cash for investors.

Income from energy may be derived via royalty trusts and master limited partnerships (MLPs). "With royalty trusts," says Chase, "you're buying a stream of income that's tied to the prices of oil and gas. Canadian royalty trusts, in particular, may offer higher yields and more tax advantages than U.S. trusts." Canadian royalty trusts such as Enerplus, Pengrowth Energy, Petrofund Energy, Provident Energy, and PrimeWest all trade in the U.S. on the New York Stock Exchange or the American Stock Exchange. Currently, they're priced to pay 8% to 10% to investors.

Unlike royalty trusts, MLPs operate a business, such as a pipeline, so they bear business risks, such as increased operating costs. You can invest in multiple MLPs through publicly traded funds, for diversification as well as for simplified tax reporting. Funds holding a basket of MLPs include Energy Income and Growth, Kayne Anderson MLP Investment, and Tortoise Energy Infrastructure.

Real estate. Housing prices continue to go through the roof. The latest National Association of Realtors report says the median price for a home in the U.S. rose 14.7% over the previous 12 months. With such price appreciation, a house with a typical 80%-financed mortgage would have given its owner a 73.5% return.

Such potential returns have the Heggans eyeing the market for investment properties. "We bought a second home in Michigan in 2000," says Darryl. "We use it for family weekends and vacations. In five years, its value has tripled."

This purchase has worked out so well that the Heggans would like to be landlords. "Once my new business is up and running," says Darryl, "we're thinking about putting more money into real estate." As Merrill Lynch's Lee puts it, "It's important for an investor to be diversified to have a well-balanced portfolio, and a balanced portfolio could include real estate."

The Heggans are thinking about buying in or near their Chicago suburb. Ann, 47, a homemaker who cares for the couple's two young children, expects to be the go-to person for any investment property they acquire. "I used to work in operations for a hotel chain," she says, "so I have an idea of what I'd have to do. I'm handy and I could do some things around the property, although I'd have to call in a plumber or an electrician for those kinds of repairs."

A three or four-family property is the most likely acquisition. "We've heard from friends who are landlords that it's hard to make money with a one- or two-family rental," says Ann. She also has learned that finding good tenants is critical to the success of such a venture.

"I've been told that we should rent to graduate students," says Ann. "They can afford to pay decent rents, they're always gone, and when they are around they're either studying or sleeping."

For any type of asset, investors should do more studying and less sleeping as the clock winds down on 2005. "Year-end is a good time for a portfolio review," says Lee. "Meet with your investment adviser to see about rebalancing your portfolio, perhaps putting money into asset classes that have lagged. You should also meet with your tax adviser to see if it makes sense to take capital gains or losses on your portfolio." Savvy moves you make by Dec. 31 may prove to be a good investment when it's time to settle up with the IRS on April 15.

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