Treasury Inflation Protected Securities seem logical in today’s market, but make sure you have a diversified, long-term strategy and don’t overload.

Question: Are TIPS a good investment today since we are facing inflation? There seems to be a lot of discussion about them, both pro and con.—Hans, Nashville, Tennessee

Answer: That depends. If by “good investment” you’re asking whether TIPS - or Treasury Inflation Protected Securities - can shield a portion of your assets from inflation then the answer is yes.

After all, that’s what TIPS are designed to do. They pay a fixed coupon rate of interest that’s lower than that of regular Treasury bonds. But the principal, or face value, of TIPS is adjusted to keep pace with changes in the consumer price index. The result is that as the CPI rises, so do the interest payments and the face value of your TIPS, giving you a sure hedge against inflation.

But if by “good investment” you are asking whether you should load up on TIPS in hopes of ratcheting up your returns by capitalizing on investors’ growing inflation fears, then my answer would be no.

Why? Well, for one thing I don’t think it ever makes sense to dramatically overhaul your portfolio to protect yourself from one particular threat or capitalize on one specific opportunity. If you’re wrong you can take a beating. You also run the risk of ending up as one of those investors who spend their time looking for the next big score, but who are more likely sabotaging themselves with lousy timing and onerous transaction fees.

And in the case of TIPS, there’s another reason this isn’t a good time to think of making a killing in them: they appear to be pretty richly priced.

As inflation fears started to pick up late last year, investors began pouring money into TIPS, driving up their prices and lowering their yields. Recently, the “real” yield on 10-year TIPS—that is, the percentage they pay above inflation—was hovering around 1.4%, quite a bit lower than the average of 2% since TIPS were introduced in 2003.

Another way of looking at that yield is to compare it to the recent yield on regular 10-year Treasuries, which, at 4.0%, was 2.6 percentage points higher than that of TIPS. Essentially, this means that for you to do better in TIPS than in regular Treasuries, inflation would have to exceed 2.6% a year for the next 10 years. That’s hardly impossible. But that margin is typically more like 2.3 percentage points, which means that at current prices TIPS already reflect higher inflation expectations than in recent years.

I’d also add that while TIPS are the surest way to hedge against inflation, there are other investments to consider, including REITs and funds that invest in natural resources and commodities.

And let’s not forget—dare I utter the word given the beating they’ve taken this year?—stocks. It’s important to understand the way in which stocks provide protection from inflation. They’re not a hedge in the sense TIPS are. Indeed, if anything, rising inflation expectations tend to drive stock prices down.

Over long run, however, stocks tend to generate the highest inflation-adjusted returns. From 1926 through 2007, for example, large-company stocks beat inflation by roughly seven percentage points annually compared with about 2.3 percentage points for intermediate-term government bonds and less than a percentage point for Treasury bills.

I’m sure I don’t have to mention that those performance stats come with a few big caveats. But I will. Those results aren’t guaranteed, the margin could very well be a lot smaller in the future and stocks can run into some severe setbacks, as they have recently.

For more on how to build a portfolio that provides a decent measure of protection against inflation but also incorporates stocks’ long-term growth potential, I suggest you check out the Inflation: 4 Ways to Protect Your Assets story in Money’s July issue.

If after reading it, you want to add some TIPS to your portfolio, you have two choices. You can buy a mutual fund that specializes in TIPS (and we just happen to have such a fund on our Money 70 list of recommended funds). Or you can buy TIPS directly from Uncle Sam.

If you plan to use TIPS primarily as a diversification tool as opposed to spending the income, I think you’ll find the mutual fund route more convenient and practical. The fund will automatically reinvest the income, plus owning a fund will make it easier for you to rebalance your portfolio. Rebalancing will also assure that you’ll end up with TIPS at a variety of prices, as you buy or sell shares over the years to maintain the target percentage of your portfolio in TIPS.

One final note. You’ll be taxed on the inflation adjustment to your TIPS’ principal even though you don’t reap that gain until the TIPS mature or you sell them. So to avoid having to fork over taxes on those gains, you’re better off holding TIPS in tax-advantaged accounts like a 401(k) or IRA.

It’s easy to want to play it safe with a large chunk of cash. But being too safe can be a big risk.

Question: I’m 49 years old and have about $1 million to invest. My mother has advised me to put it all in 30-year muni bonds and CDs, but I wonder whether I ought to be more diversified. Do you think I should take my mom’s advice? —C. Hilliard

Answer: Normally, moms are a font of good common-sense advice, encouraging us to eat our vegetables, play nicely with others and, of course, imparting that time-honored admonition: “Don’t run holding that stick. You’ll poke your eye out!”

But as much as I hate to do it, I’m afraid I have to tell you that you should ignore your mom’s investing advice, which is bad on several levels.

Take her muni bond recommendation. Sure, bonds should be part of a well-balanced portfolio and, depending on your tax rate, munis can be an excellent way to get that exposure in taxable accounts, especially today when muni yields are competitive with those of Treasury bonds in many cases, even without factoring in munis’ tax benefits.

But by investing solely in long-term munis - as opposed to also holding short- and/or intermediate-term bonds - you are taking a big risk. The threat isn’t that the bonds might default. As long as you stick to high-quality munis the chances of that are actually pretty slim. Rather, the problem has to do with the seesaw relationship between interest rates and bond prices - namely, when interest rates rise, bond prices fall. And generally the longer the maturity, the steeper the drop.

I’m not in the business of making interest-rate predictions. But given all that Big Ben Bernanke and his colleagues at the Fed have been doing to stimulate the economy, I don’t think it’s a stretch to wonder whether we might be in for higher inflation and higher interest rates at some point in the near future.

But whatever the outlook, I still think it’s best to hedge your bets by sticking to bonds, or bond funds, with maturities at the short- to intermediate-end of the maturity spectrum. You’ll collect most of the yield of longer-term issues with much less volatility.

But the even bigger problem with mom’s recommendation is that it would leave you with all of your money in fixed-income investments. That might be fine if you were, like, 90 years old. (Even then, 100% in fixed-income wouldn’t automatically be the way to go.) But you’re a mere youngster of 49, for goodness sake. At this point in your life, you still need some long-term growth to boost the purchasing power of your portfolio so it can support you throughout retirement. And to get that growth, you’ve got to diversify into stocks.

So the challenge you face is putting together a diversified portfolio of stocks and bonds that gives you a decent shot at long-term growth but also provides enough stability so that your portfolio won’t get totally hammered if the stock market drops or interest rates rise.

In order to meet that challenge, you’ll have to grapple with two fundamental questions: How should you divvy up your holdings between stocks and bonds? And then, which types of stocks and bonds should you invest in?

There are no one-size-fits-all answers. It largely comes down to how much risk you’re willing to take, what size returns you want to shoot for and how hard you want to work at creating and then monitoring your portfolio. But you can get advice both on how to allocate your holdings between stocks and bonds as well as on specific investments by checking out this month’s Money cover story, “The Only 7 Investments You Need Now.”

I’ll leave it to you as to the best way to handle your mother if she asks you whether you followed her advice. But there is a way you can be truthful but also let her down easy. Just say, “Remember, mom, how you always told me to eat a balanced diet? Well, I’m applying your excellent advice to my investment portfolio.”

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This isn’t the first, or the last time we’ve faced economic uncertainly, but with 30 or 40 years until retirement, there’s no need to rush out of the market.

Question: I’m 28 and have my Roth IRA in a 2045 target-date retirement fund. In the last couple of months, I’ve lost almost an entire year and a half’s worth of profits. I want to keep contributing to my Roth, but I’m concerned about the possibility of recession and all that’s going on in the market. What do you think - should I try something else or just suck it up and keep investing in the same fund? –A.P., Crofton, Maryland

Answer: It’s perfectly natural for you to be anxious or even scared at times like this. Read the newspapers and you almost can’t help but come away with the impression that we’re in the midst of a total financial meltdown, an economic Armageddon, so to speak.

Combine this sense that the system is ready to come crashing down around us at any moment with the fact that the broad stock market is down about 15% from its peak last October and it’s no wonder you’ve begun second-guessing your decision to invest your Roth money in a target-retirement fund that, given your age, is probably about 90% or so invested in stocks.

But as much as I understand your urge to abandon your plan, I think it would be a mistake.

That said, I don’t think the solution is to just “suck it up.” That suggests a certain macho attitude that may have a place in certain sports, but isn’t really appropriate to investing. Ration and clear thinking are what’s needed to succeed as an investor.

Question: I’m 68, recently retired and have $250,000 to invest. I don’t know much about finances and I’m confused by all the information out there. I know I should diversify, but how do I determine where to put my money? –Grace, Yukon, Ohio

Answer: Well, you say you don’t know much about finances, but at least you know that you should diversify your $250,000 rather than plow it all into any one type of investment.

That’s a good start, especially given the precarious state of the financial markets today. People who went overboard on one asset class because it seemed like a sure thing just a couple years ago - real estate, financial stocks, whatever - are now paying the price, while people who take the same approach today with the hot investments du jour - gold and commodities come to mind - may end up paying the price tomorrow.

But as crucial as asset allocation is it’s still not as important as the factor you’re apparently overlooking: you.

That’s right, knowing all about building a well-balanced portfolio with different asset classes that work in concert with each other doesn’t mean anything if you haven’t first asked yourself what exactly you are trying to achieve by investing this money.

If this is an extra stash you probably won’t have to touch and will likely leave to your heirs, then you don’t have to worry so much about short-term losses and you may be able to invest more aggressively than is typical for someone your age.

If, on the other hand, you’re going to be drawing on this money for regular income to supplement Social Security, then you can’t afford to risk big setbacks because the combination of market losses and withdrawals can put a big dent in our portfolio’s value, raising the possibility that you could run through your two hundred and fifty grand too soon.

You’ve also got to take your emotional and psychological makeup into account. It’s one thing to say that you’re capable of riding out ups and downs in the market because you know that stocks usually generate the highest returns over the long run. But will you feel that way if the value of your holdings has dropped by 20% or 30%? Or at that point will you more likely be dumping everything you can and fleeing for the safety of CDs?

You can’t compensate too much on the side of safety, however, and just plow virtually all your money into CDs and money-market funds - unless you don’t mind the fact that the purchasing power of your money is likely to drop over the long-term after taxes and inflation.

I think that most people can sort through these issues and come up with a reasonable mix of assets that gives them enough upside potential to earn decent returns while maintaining sufficient downside protection against stomach-churning losses.

By answering a few simple questions about your risk tolerance, and how long you plan to have your money invested, for example, our Asset Allocator tool will suggest an appropriate mix of stocks and bonds. You can then go either to our Fund Screener or consult our Money 70 list of recommended mutual funds to find specific funds to fill that suggested mix.

If you’re going to be relying on your $250,000 for retirement income, I’d suggest you check out T. Rowe Price’s Retirement Income Calculator. You’ll get an estimate of how long your money is likely to last. You can then try different investment strategies and withdrawal rates to see whether your money lasts longer or goes sooner.

But, again, you’ve got to consider the “you” factor. If you feel overwhelmed when you start to deal with different investment alternatives or you’re just not confident about revving up calculators and the like, then you should probably get some professional help.

You’ve got several choices. You can hire a financial planner who can take a look at your overall situation, discuss your goals and come up with a plan. Typically, planners want an ongoing relationship, which means paying a certain percentage of your assets in fees each year (although some are willing to work on a flat-fee or hourly basis). Many large investment firms and mutual fund companies also give investment and planning advice these days.

Be careful, though. There are lots of people out there posing as advisers who are really peddling high-priced investment products or just looking to rip you off; $250,000 throws off more than enough scent to bring such opportunists and scam artists flocking to your door.

Whatever you do, don’t rush. Better to take some extra time and make a good decision that perhaps you could have made sooner than to move quickly and end up regretting that you did.

A diversified strategy and periodic readjustments will help you steer clear of market madness. Tune out all the noise and stick to the game plan.

Question: I generally review my portfolio twice a year to see if I need to make any adjustments. But given that the market has been down in recent months, I’m wondering whether I’m better off waiting until the market rebounds or sticking to my usual schedule. What do you think? –Todd M., Bryan, Ohio

Answer: I assume that when you talk about adjusting your portfolio twice a year, you mean that you’re rebalancing to bring your mix of stocks and bonds back to its original proportions.

And if that’s the case, then the strategy you’ve been following up to now makes perfect sense to me. As different investments earn different returns, your portfolio’s proportions will shift over time. So you periodically need to sell some shares of investments that have done relatively well and plow the proceeds into those that have trailed - or just funnel new money into laggards - to bring your portfolio back to its proper balance of risk vs. return.

Granted, one could argue about which of the many different rebalancing strategies available is the most effective. (I’m a member of the “once a year is enough” club myself, mostly because it’s easy and investors are more likely to stick with what’s simple.) But the most important thing is that you’re consistent - that is, you choose a method and then stick to it.

All of which is to say that I believe you ought to think twice - or maybe even three or four times - before you abandon your current strategy.

I can understand why you might have the urge to change your game plan. You’re no doubt hoping that by waiting a bit some of your battered investments will recover and you won’t have to realize losses.

But the whole point of building a mix of different types of assets based on your goals, time horizon and risk tolerance, and then rebalancing back to that blend on a regular basis is that you can’t predict the future. You don’t know when the market will fall or when it will recover. You don’t know the best time to get out of stocks and into bonds or vice versa. You don’t even know when it’s the ideal time to rebalance your portfolio, except in retrospect, of course.

So to deal with that lack of knowledge, you create a strategy, a disciplined system that can help guide you through the uncertainty.

I know that some people may see this as a head-in-the-sand approach especially given what’s been going on lately, what with major investment bank Bear Stearns getting snapped up at a fire-sale price, the Fed scrambling to keep the economy afloat and investors worldwide wondering what the next shock might be.

After all, in fast-moving and perilous times like these, don’t you have to be most nimble, most flexible, most willing to try something new?

Actually, no. It’s in times of crisis when you most need to stick to your plan. The far bigger danger in a volatile market like today’s is that you end up making a move that seems brilliant at the moment but turns out to be not so smart in the future.

Or, if you really get into the spirit of second-guessing your plan, maybe you end up making a series of such moves as you react differently to each crisis du jour.

That’s not to say you can’t ever deviate from your plan. If you find that you don’t have the stomach for risk you thought you had when you created your portfolio - it’s not unusual for investors to overestimate their appetite for volatility when the market is doing well - then maybe you need to scale back your stock holdings a bit. And if that’s the case, there’s no need to wait until you make your usual adjustment.

Similarly, if you’ve concluded after careful deliberation that some of your stocks or funds are clunkers that need to be replaced quickly, then replace them as soon as you find acceptable substitutes. You might even want to occasionally sell some holdings in taxable accounts to reap tax losses that can be used to offset other gains or even ordinary income.

But, remember, if you stray from your game plan too often and begin basing your rebalancing decisions on gut feelings about what the market may or may not do and when it might or might not do it, then you don’t really have a plan anymore. You’re just playing hunches.