“Smart investors allocate their assets into investment classes and investment sectors that are favored by long-term trends.”

“You can diversify your portfolio among the best sectors within an investment class.”

The one great flaw in asset allocation theory in practice is that it rarely reflects the distinct, predictable seasons of the economy . Furthermore, most of us have about a 10 to 30-year time horizon for investing; not the 70-year horizon used in the Ibbotson studies for developing modern portfolio theory. Maximizing your returns depends on knowing the right balance of asset classes that are favored by fundamental trends during the different economic seasons over the actual life of your portfolio. It also depends on using the two techniques I recommend to actively rebalance your portfolio, static (or periodic) portfolio rebalancing and dynamic portfolio rebalancing .

Since 1926, the first year of data used in most asset allocation research, there have been dramatically different >seasons in our economy and the investing environment. Would you have wanted to use the same portfolio strategy in the Roaring 20s as you used in the Great Depression of the 1930s? Would the same mix of equities have performed equally well in the inflation and recession of the 1970s versus the disinflation and boom of the 1980s? Will you manage your portfolio the same way in this decade, a boom period with surging productivity and relatively flat inflation, as you will after around 2008 to 2010, when our economy moves into the next depression era? The answer is clearly “no.”

In the coming decade, two of the four standard asset classes will be a great investment, large cap stocks and most international equities. Small caps will do better than they did in the 1990s. Yet they will not rival large caps, particularly as we move closer to the top of the boom in 2008 and see a race for market leadership and industry consolidation.

After 2008 when the economy begins a Deflationary Shakeout, similar to the 1930s depression era, you will have fewer options for diversifying your portfolio among the standard asset classes. Your best investments will be long-term bonds and select international stocks . After the market has bottomed, however, you will be able to add a third asset class and begin to buy small cap stocks.

Here is the key question: If asset allocation theory says to diversify among all four broad investment classes, yet fundamental economic trends favor only two of them, how do you diversify your portfolio? The answer comes from understanding another simple principle. The four classes ; large caps, small caps, international and fixed income ; are not the only kinds of investments that move in low-correlating patterns to provide effective diversification. There are many sectors within a broad asset class that fit your risk profile and give you high returns. For example:

• Within the international sector there is a vast difference in the risks and returns among broad geographic regions like Europe, Asia and Latin America. You can further diversify this one sector by choosing to invest in developed countries or to invest in emerging countries .
• Within the booming large cap domestic arena, you can focus on the sectors that are outperforming but also diversify effectively.

Here’s the sound strategy that I’ve developed for beating the S&P 500 over the coming decade. Pick the highest-return sectors that benefit from the current fundamental trend, which is the Growth Boom, phase two right now, and combine them for effective diversification. The sectors I favor must meet four conditions. They

I have developed an aggressive growth portfolio that meets these four conditions. I call it the ultimate portfolio strategy for the Roaring 2000s. It focuses on large cap technology, financial services, and health care domestically, and Asia (excluding Japan) internationally.