Many people in the investment industry promote asset allocation funds as a simple and profitable way to assemble a diversified portfolio of stocks, bonds and cash equivalents.

But as is so often the case, the product rarely lives up to the hype.

How asset allocation funds actually work

Asset allocation funds are mutual funds that can shift their portfolio allocations between stocks, bonds and cash in order to capitalize on perceived investment opportunities in any one of those classes.

For example, if the managers are convinced the bond market is depressed and due for an upswing, they may invest heavily in fixed-income investments for a few months to take advantage of the change.

Some managers make their own judgments when choosing between stocks, bonds and cash. Others use what insiders call a “black box” — a computer program that makes trading decisions based on a preselected set of rules for interpreting financial statistics.

Computer modelling makes this investment approach sound scientific and relatively foolproof. Yet it is just as likely to detract from a portfolio’s long-term return as it is to add to it.

Low interest rates make now an unpromising time to hold bonds

Bond performance is inversely related to the rise and fall of interest rates; when rates fall, bond prices go up.

Did your broker tell you about the investment that soared 119.1% in just 8 months while generating a hefty 5.7% current yield? Canadian Wealth Advisor subscribers regularly get the "inside track" on these types of high-quality "safe money" investments. Now you can join them. Click here to learn how you can profit from Canadian Wealth Advisor.

With interest rates continuing to remain at low levels, bonds can’t go a lot higher than they are. In fact, bond prices will likely fall over the next few years as interest rates inevitably rise again. That means asset allocation funds would only earn interest income on their bonds; in place of capital gains, their bond holdings could produce capital losses.

Our long-term strategy can generate more lower-risk profits

Instead of asset allocation funds, we continue to recommend that you invest in well-established, high-quality dividend-paying stocks, like those we recommend in our newsletters.

Moreover, you can reduce risk considerably by spreading your money out across most, if not all, of the five main economic sectors (Manufacturing & Industry; Resources; Consumer; Finance; and Utilities). This way, you avoid overloading yourself with stocks that are about to slump simply because of industry conditions or changes in investor opinion.

You also increase your chances of finding a stock that could surge and rise above the market average.

A better way to hold fixed income investments

If you are reluctant to hold a 100%-stocks portfolio then one alternative to consider is to keep a portion of your investment funds in relatively short-term fixed-return investments, with maturity dates of a few months to no more than two to three years in the future.

These fixed-return investments will lose value when interest rates rise, but not enough to make a serious dent in their value. You can hold them till maturity, then get your money back and reinvest.

Our newsletter for conservative investing, Canadian Wealth Advisor, shows you how to protect your money and keep it safe—without sacrificing the potential for strong returns.

You can get a special risk-free introductory subscription to Canadian Wealth Advisor at a savings of $50.00 off the regular rate. Best of all, your FREE trial contains 5 in-depth Special Reports, and much more. Don’t wait! Click here to get started right away.

The fund’s top holdings are CIBC, 6.6%; Bank of Montreal, 5.3%; Bonterra Energy, 5.2%; National Bank, 4.9%; TD Bank, 4.9%; Telus, 4.8%; IGM Financial, 4.3%; Enbridge, 4.2%; BCE, 4.2%; Canadian Utilities, 3.7%; and Manitoba Telecom, 3.7%.

The fund holds 50.2% of its assets in financial stocks. Utilities are next, at 26.4%. The top Canadian finance stocks have sound prospects. However, if you invest in this ETF, be sure to adjust the rest of your portfolio so it won’t be overly concentrated in the financial sector.

iShares Dow Jones Canada Select Dividend Index Fund is a buy.

Most of the stocks in the index are high-quality companies. However, as it must ensure that all sectors are represented, it holds a few we wouldn’t include.

The index’s top holdings are Royal Bank, 6.7%; TD Bank, 6.4%; Bank of Nova Scotia, 5.5%; Barrick Gold, 4.8%; Suncor Energy, 4.1%; Potash Corp., 3.9%; Goldcorp, 3.8%; Bank of Montreal, 3.7%; Canadian Natural Resources, 3.2%; CN Railway, 3.2%; BCE Inc., 3.0%, TransCanada Corp., 2.9%, CIBC, 2.9%; Enbridge, 2.6%; Cenovus Energy, 2.3% and Manulife Financial, 2.1%.

iShares S&P/TSX 60 Index Fund is a buy.

The bonds in the index are 70.6% government and 29.4% corporate.

The fund yields 3.6%, compared to the Short Term Bond Fund’s 3.2%. Its yield to maturity is 2.40%, 0.88% above the Short Term Fund. That reflects the added risk of holding long-term bonds.

iShares DEX Universe Bond Fund is a buy for safety-conscious investors who can accept that risk.

This index consists of a wide range of investment-grade federal, provincial, municipal and corporate bonds with between one- and five-year terms to maturity. The fund holds 264 bonds with an average term to maturity of 2.85 years. The bonds in the index are 66.7% government and 33.3% corporate. The fund’s MER is 0.26%.

iShares DEX Short Term Bond Index Fund yields 3.2%. However, this high yield is due to the fact that some of the fund’s bonds pay above-market interest rates. But as a result, they trade above their face value. When these bonds mature, holders will only get the bonds’ face value, which means the portfolio will incur predictable capital losses. These losses will offset some of the appeal of the above-market yields.

The key figure when looking at the long-term return of this fund is yield to maturity. This yield takes into account the series of capital losses the fund will experience as its above-market-rate bonds mature. iShares DEX Short Term Bond Index Fund’s yield to maturity is around 1.52% — less than the 3.2% yield, but still higher than the 0.92% you’d earn by investing in, say, a one-year T-bill.

If you want to invest in a bond fund, iShares DEX Short Term Bond Index Fund is a buy.

Still, the long-term outlook is for higher interest rates. The heavy deficit spending of the past few years and the expansion of the money supply, which is still underway, increase the potential for even higher inflation.

We continue to advise against investing in bonds right now, because today’s low interest rates make them unattractive — and rising interest rates would push down their value.

However, if you need stable income and want to hold bonds, here are two bond funds that have low fees and high-quality holdings.

ISHARES DEX SHORT TERM BOND INDEX FUND $29.29 (CWA Rating: Income) (Toronto symbol XSB; buy or sell through a broker) mirrors the performance of the DEX Short-Term Bond Index.

This index consists of a wide range of investment-grade federal, provincial, municipal and corporate bonds with between one- and five-year terms to maturity. The fund holds 264 bonds with an average term to maturity of 2.85 years. The bonds in the index are 66.7% government and 33.3% corporate. The fund’s MER is 0.26%.

iShares DEX Short Term Bond Index Fund yields 3.2%. However, this high yield is due to the fact that some of the fund’s bonds pay above-market interest rates. But as a result, they trade above their face value. When these bonds mature, holders will only get the bonds’ face value, which means the portfolio will incur predictable capital losses. These losses will offset some of the appeal of the above-market yields.

The key figure when looking at the long-term return of this fund is yield to maturity. This yield takes into account the series of capital losses the fund will experience as its above-market-rate bonds mature. iShares DEX Short Term Bond Index Fund’s yield to maturity is around 1.52% — less than the 3.2% yield, but still higher than the 0.92% you’d earn by investing in, say, a one-year T-bill.

If you want to invest in a bond fund, iShares DEX Short Term Bond Index Fund is a buy.

ISHARES DEX UNIVERSE BOND INDEX FUND $31.08 (CWA Rating: Income) (Toronto symbol XBB; buy or sell through a broker) mirrors the performance of the DEX Universe Bond Index. The 502 bonds in the portfolio have an average term to maturity of 9.31 years. The fund’s MER is 0.32%.

The bonds in the index are 70.6% government and 29.4% corporate.

The fund yields 3.6%, compared to the Short Term Bond Fund’s 3.2%. Its yield to maturity is 2.40%, 0.88% above the Short Term Fund. That reflects the added risk of holding long-term bonds.

iShares DEX Universe Bond Fund is a buy for safety-conscious investors who can accept that risk.

What you get when you buy units of asset allocation funds

Asset allocation funds are mutual funds that can shift their portfolio allocations between stocks, bonds and cash in order to capitalize on perceived investment opportunities in any one of those classes.

For example, if the managers feel that the bond market is depressed and poised for an upswing, they may invest heavily in fixed-income investments for a few months to take advantage of the change.

Some managers make their own judgments when choosing between stocks, bonds and cash. Others use a so-called “black box” — a computer program that makes trading decisions based on a preselected set of rules for interpreting financial statistics.

Computer modelling makes this investment approach sound scientific, but it is just as likely to detract from a portfolio’s long-term return as it is to add to it.

Low interest rates make now a bad time to hold bonds, either directly or through asset allocation funds

Bond performance is inversely related to the rise and fall of interest rates; when rates fall, bond prices go up.

Did your broker tell you about the investment that soared 119.1% in just 8 months while generating a hefty 5.7% current yield? Canadian Wealth Advisor subscribers regularly get the "inside track" on these types of high-quality "safe money" investments. Now you can join them. Click here to learn how you can profit from Canadian Wealth Advisor.

With interest rates now at historic lows, bonds can’t go a lot higher than they are. In fact, bond prices will likely fall over the next few years as interest rates inevitably rise again. That means asset allocation funds would only earn interest income on their bonds; instead of capital gains, their bond holdings could produce capital losses.

Our long-term strategy puts you in a better position for lower-risk profits than asset allocation funds

Instead of asset allocation funds, we continue to recommend that you invest in well-established, high-quality dividend-paying stocks, like those we recommend in our newsletters, including our flagship publication, The Successful Investor.

Moreover, you can eliminate market-timing risk by spreading your money out across most, if not all, of the five main economic sectors (Manufacturing & Industry; Resources; Consumer; Finance; and Utilities). This way, you avoid overloading yourself with stocks that are about to slump simply because of industry conditions or changes in investor opinion.

You also increase your chances of stumbling upon a market superstar — a stock that does two to three (or more) times better than the market average.

If you want to hold fixed income investments…

If you are reluctant to hold a 100%-stocks portfolio—and many people are—then one alternative to consider is to keep a portion of your investment funds in relatively short-term fixed-return investments, with maturity dates of a few months to no more than two to three years in the future.

These fixed-return investments will lose value when interest rates rise, but not enough to make a serious dent in their value. You can hold them till maturity, then get your money back and reinvest.

You can get our latest risk-cutting strategies and clear, plain-English analysis of dozens of Canadian stocks in The Successful Investor. What’s more, you can get one month free when you subscribe today. Click here to learn how.

Most of the stocks in the index are high-quality companies. However, as it must ensure that all sectors are represented, it holds a few we wouldn’t include, such as Yellow Media Inc.

The index’s top holdings are: Royal Bank, 6.9%; TD Bank, 6.3%; Bank of Nova Scotia, 5.4%; Suncor Energy, 5.2%; Potash Corp., 4.1%; Canadian Natural Resources, 3.9%; Barrick Gold, 3.9%; Goldcorp, 3.2%; CN Railway, 3.1%; Bank of Montreal, 3.1%; Manulife Financial, 2.6%; CIBC, 2.6%; BCE, 2.5%; TransCanada Corp., 2.5%; Cenovus Energy, 2.3%; and Teck Resources, 2.2%.

iShares S&P/TSX 60 Index Fund is a buy.

The index’s top holdings are Royal Bank, 6.0%; TD Bank, 5.4%; Bank of Nova Scotia, 4.8%; Suncor Energy, 4.7%; Potash Corp., 3.6%; Canadian Natural Resources, 3.4%; Barrick Gold, 3.4%; Goldcorp, 2.9%; Bank of Montreal, 2.6%; CN Railway, 2.6%; CIBC, 2.4%; Manulife Financial, 2.3%; TransCanada Corp., 2.3%; and Teck Resources, 2.2%.

If you want to own a Canadian index fund, you should buy the iShares S&P/TSX 60 Index Fund. You’ll pay about a third of the management fees.

We don’t recommend iShares MSCI Canada.

Silver could well regain its high and move up even further over the longer term, although it will likely remain volatile. Higher prices would arise from investor fears that inflation or global political and economic uncertainty will weaken key currencies, such as the U.S. dollar.

Use caution when investing in silver

Silver prices tend to rise along with gold prices. That’s because when gold prices soar, as they have lately, investors see silver as less of an industrial commodity and more as a precious metal. Sometimes known as “poor man’s gold,” silver attracts a lot of interest as gold prices reach levels that seem too expensive for the average investor.

Conservative investors should limit their total silver investments, as they would with any volatile commodity investment. Further, silver should only make up a portion of the resources segment of your portfolio.

Look to exchange-traded funds (ETFs) for convenient, low-cost silver investing

If you want to invest in silver, we think the best way to do it is through silver-mining stocks. We recommend staying away from silver bullion, certificates representing an interest in bullion, and other silver bullion alternatives, such as so-called “junk silver” coins (these are common coins with no numismatic value that trade strictly on their silver content).

Commodity investments like these do not generate income. Instead, they come with a continuing cash drain for management, insurance and so on.

Did your broker tell you about the investment that soared 119.1% in just 8 months while generating a hefty 5.7% current yield? Canadian Wealth Advisor subscribers regularly get the "inside track" on these types of high-quality "safe money" investments. Now you can join them. Click here to learn how you can profit from Canadian Wealth Advisor.

You can hold silver stocks directly, through mutual funds, or through exchange traded funds like Global X Silver Miners ETF (symbol SIL on New York). We analyzed this ETF in a recent issue of our Canadian Wealth Advisor newsletter.

This exchange traded fund’s holdings include leading silver miners

Global X Silver Miners ETF tracks the Solactive Global Silver Miners Index, which includes between 20 and 40 international companies that mine, refine or explore for silver.

Global X Silver Miners ETF began trading on April 19, 2010.

Canadian-based companies make up 58.7% Global X Silver Miners ETF’s holdings, but it also includes companies based in the U.S. (11.3%) and Mexico (11.1%). The exchange traded fund’s MER is 0.65%.

The exchange traded fund’s top-ten holdings are Silver Wheaton at 12.7%; Industrias Penoles, 11.1%; Fresnillo plc, 10.4%; Pan American Silver, 9.8%; First Majestic Silver, 9.8%; Coeur d’Alene Mines, 5.6%; Silvercorp Minerals, 5.2%; Hochschild Mining plc, 4.5%; Hecla Mining, 4.4%; and Silver Standard Resources, 4.3%.

You can get our full analysis of Global X Silver Miners ETF in Canadian Wealth Advisor. Best of all, you can get the latest issue ABSOLUTELY FREE, along with 5 in-depth Special Reports, when you take a no-risk, 1-month FREE trial to Canadian Wealth Advisor today.

Don’t wait! Click here start your 1-month FREE trial to Canadian Wealth Advisor now.