Build your nest egg like Grandpa did

The go-go days got us good

Investors in the great bull market of 1982-2000 completely lost sight of Grandpa-style investing because of what now appears to have been a once-in-a-lifetime orgy of capital gains. And unfortunately, today's investors cut our teeth in that market. We continue to pine for annual double-digit gains in stock prices, dividends be damned.

And bonds? Compared with a hot high-tech IPO, they're like kissing your sister.

But in this decade, as in the 1950s, the only real returns are coming from interest and dividends. In the past 12 months, which have been among the worst in U.S. market history, balanced funds are down 27.4%, growth-and-income funds 33.3%, growth funds 38.4%, foreign stocks 48.7% and emerging markets 52.4%.

The difference is dividends. Balanced funds are typically 40% high-quality stocks and 60% blue-chip stocks; growth-and-income funds are typically 20% bonds and 80% stocks. And the latter's holdings are usually loaded with dividend payers. The average dividend yield of a growth-and-income fund is 2.76%. For a growth fund, it's 1.01%.

Virtually every mutual fund complex and 401(k) plan offers a balanced fund, and most have excellent portfolios of the growth-and-income type. Unfortunately, these categories are considered old-fashioned, so the labels sometimes don't appear outside a fund's prospectus.

For example, top balanced funds that lack the signal word include Oakmark Equity & Income I (OAKBX) and II (OARBX), and FPA Crescent (FPACX). Morningstar calls all these moderate allocation funds.

Similarly, excellent growth-and-income funds include Philadelphia Fund (PHILX) and Loomis Sayles Value Y (LSGIX), both called large value by Morningstar, and Ivy Dividend Opportunities Y (IVDYX), labeled large blend.

The mix of stocks and bonds

The crucial concept to keep in mind is a blend of high-quality bonds and market-leading, dividend-paying stocks. Index investors can easily manufacture such a portfolio by combining the Vanguard Total Bond Market Index (BND) exchange-traded fund and Vanguard Value ETF (VTV) or mutual-fund analogs, in a ratio of up to 40% bonds and the rest stocks.

The interest and dividends that this approach pays will provide a reliable positive cash flow for its owner, as well as the opportunity for decent capital appreciation. The 40-60 blend of this mix, represented by Vanguard Balanced Index Fund (VBINX), has delivered annualized returns of 6.52% over the past 15 years. The vastly larger but substantially more risky Vanguard 500 Index (VFINX) has returned 6.84%, not nearly enough of a difference to compensate shareholders for that additional risk.

Assuming you've got lots of fashionable but highly unprofitable risky assets, a recession is a great time to upgrade your holdings to the most solid, dependable investments, because they're on sale along with everything else. In today's investment climate, you can do no better than buying the best, most secure American securities.

Except, as I've noted before, U.S. Treasury bonds. They are vastly overpriced exactly because their quality is unparalleled; their return right now is basically zilch. But they are just about the only thing overpriced today.

Most bonds and virtually all blue-chip stocks are on special, selling at prices we won't see again for some time.

Meet Middleton at The World Money Show

MSN Money's Tim Middleton will be among more than 100 investment and finance experts sharing their advice on what to buy and sell in 2009 at The World Money Show in Orlando, Fla., Feb. 4-7. Invest four days dedicated to planning and refining your portfolio by attending some of the event's more than 300 workshops and panel presentations.

Admission is free for MSN Money readers. To sign up, call 1-800-970-4355 and mention priority code No. 012661, or register online.

At the time of publication, Tim Middleton owned the following fund mentioned in this article: Vanguard Total Bond Market Index.

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