The Only 7 Investments You Need

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3. A Small-Company Fund

First choice: T. Rowe Price New Horizons (PRNHX)

The greatest returns in the stock market come from taking above-average risks. That's why over periods of a decade or longer, small-company funds - which own shares of small, dynamic companies - can outpace the rest of the market by an average of one to three percentage points a year.

This isn't the only reason to carve out a permanent niche in your portfolio for such funds. They sometimes pick up steam just when blue chips stagnate, making them a great diversifier. In the 1970s, for instance, small stocks delivered nearly twice the gains of blue chips.

"Adding that small-cap performance gives you a nice extra bit of diversification," says Frank Armstrong, founder of the advisory firm Investor Solutions. This category makes particular sense when you're decades from needing to tap your portfolio. The farther off that goal, the more time you have to benefit from small-stock funds' long-term growth, and the less you need to worry about their periodic nosedives.

Most of our first-choice picks are index funds, but this one is an exception: T. Rowe Price New Horizons. In this category, it may be worth paying slightly more - just slightly - for active management, and New Horizons is one of the most efficient of the actively managed crowd.

Alternatives: Vanguard Small-Cap Index (NAESX) and Vanguard Small-Cap ETF (VB)

4. A Value Fund

First choice: Vanguard Value Index (VIVAX)

The universe of equities is divided into two groups: growth stocks, which are shares of high-performing companies that often trade at steep prices (relative to their earnings growth or assets); and value investments, overlooked or beaten-down shares selling at discount prices. Why do you need to bother with the bargain-basement bin?

For starters, value stocks typically pay out significantly higher dividends than growth companies. Today, in fact, the average value stock in the S&P 500 yields 3.5% - nearly twice what growth stocks pay out. Dividends give value stocks a steadier source of return than growth funds, which rely almost entirely on the market's opinion. That's one reason that over long stretches, value trumps growth more often than not.

In the equity investors' bible, "Stocks for the Long Run," University of Pennsylvania professor Jeremy Siegel points out that value returned an average of 15.7% a year between 1975 and 2001, nearly two points a year more than growth stocks.

When choosing a value fund, the last thing you want to do is overpay. Vanguard Value Index is a cost-effective way to buy the universe of blue-chip value stocks for just 0.20% in annual fees. The low costs explain how this plain-vanilla fund has returned about 13% a year since 2003, beating 78% of its peers.

Alternatives: iShares S&P 500 Value Index (IVE) and T. Rowe Price Equity Income (PRFDX)

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