25 Rules to Grow Rich By

Follow these guidelines and feel confident that you'll be making the right financial decisions.

1. For return on investment, the best home renovation is to upgrade an old bathroom. Kitchens come in second.
The return on investment on a mid-range bath modernization is 102% of its cost. Kitchens can add about 90% of their costs to the home's value.

Another home improvement that can pay off is window replacement. Not only does this job return about 90% on investment when the house is resold, it saves on energy bills every year.

As a rule, upscale improvements pay off at lower rates than mid-range or inexpensive ones. And making a house bigger and more luxurious that those of your neighbors will also cost a lot more than they'll return when the house is sold.

2. It's worth refinancing your mortgage when you can cut your interest rate by at least one point.
There are transaction costs and fees involved in any refinancing that must be either paid out of pocket or added to the mortgage principal. Some of those costs can be considerable. Title insurance can easily run into four figures and broker fees can be expensive as well.

Like many things in life, timing is everything here. Is your job likely to relocate soon? Will you need a bigger house in the next couple of years? Unless you're planning to stay in the home for a while, the benefits of a lower monthly bill may not be worth the additional expenses that refinancing generates.

3. Spend no more than 2 1/2 times your income on a home. For a down payment, it's best to come up with at least 20%.
Many buyers in recent years have stretched the limits of affordability, and have bypassed the traditional 20% down model. But make a smaller down payment, and most lenders will require you to have private mortgage insurance (PMI), which adds a minimum 0.5% of the loan amount to your mortgage payments, about $1,000 more a year on a $200,000 principal.

4. Your total housing payments should not exceed 28% of your gross income. Total debt payments should come in under 36%.
These guidelines include payment on all loans, such as school and auto loans and credit card debt.

Also remember to take into account other home-related expenses to judge a house's affordability. Property and school taxes, home insurance and energy costs and requirements can vary considerably around the nation.

Try to estimate future maintenance costs and work them into your budget. Some homes, especially older ones, may require more regular upkeep than homes built with more modern materials. Roofs, siding and heating, cooling, plumbing, and electric services may have to be replaced within a few years of purchase.

5. Never hire a roofer, driveway paver or chimney sweep who is going door to door.
Even if these contractors aren't scam artists, they may lack licensing and insurance. If a worker gets hurt on your property it could wind up costing a lot more than you bargained for.

Instead, get contractor recommendations from friends, neighbors or relatives. Check references and get documentation of insurance coverage.

And don't put more than 10% down for the job. Mete out the payments gradually as work is done and withhold the final 25% until you're satisfied with the completed project.

6. All else being equal, the best place to invest is a 401(k). Once you've earned the full company match, max out a Roth IRA. Still have money to invest? Put more in your 401(k) or a traditional IRA.
One of the keys to saving for the long run is keeping as much money as possible shielded from taxes. A 401(k) gives you that and more: You also get an immediate tax break, because contributions come out of your paycheck before taxes are withheld. And there's the possibility of a matching contribution from your employer – that's free money.

The federal limit on annual contributions has been increasing gradually, and is $15,000 in 2006. If you're 50 or older, you may contribute an additional $5,000.

With a Roth IRA, you get no immediate tax break, but withdrawals in retirement will be tax-free. You can make at least a partial contribution to a Roth if your modified adjusted gross income is less than $110,000, if you're single, or less than $160,000, if you're married and filing jointly.

7. To figure out what percentage of your money should be in stocks, subtract your age from 120.
Since 1926, stocks have returned an annual average of 10.5 percent, long-term government bonds returned 5.1 percent, and "cash," measured by Treasury bills and other short-term investments, has returned just 3.1 percent. In other words, if you're investing for the long-term, stocks are the place to be. But in the short term, the stock market can be downright dangerous, with much more severe drops than the bond market has.

That's where this rule comes in - the younger you are, the more time you have to recover from stock-market crashes. As you get older, you should gradually move money out of stocks and into bonds.

8. Invest no more than 10% of your portfolio in your company stock - or any single company's stock, for that matter.
In a bear market, it's tough to find a safe-haven – a lot of the stocks in your portfolio will be sinking too. But don't compound the risk by holding too much in any one stock.

The most recent dramatic example of just how serious this "specific-stock" risk can be is Enron, which imploded after its executives allegedly engaged in various acts of malfeasance. But a company with perfectly honest management might fall on hard times too.

And if it's your employer's stock, you're in an even worse position – not only will your portfolio be decimated, but your job could be at risk too.

9. The most you should pay in annual fees for a mutual fund is 1% for a large-company stock fund, 1.3% for any other type of stock fund and 0.6% for a U.S. bond fund.
Running a mutual fund isn't free – companies have to pay for research, managers' salaries, and so on. Those costs are borne by the investors in the funds and get deducted from returns. A percentage point here and there may not sound like much, but a fund manager needs to pick a lot of great stocks to make up for those costs.

10. Aim to build a retirement nest egg that is 25 times the annual investment income you need.
So if you want $40,000 a year to supplement Social Security and a pension, you must save $1 million. This rule is based on the amount that you can safely withdraw from your nest egg in retirement.

The single most effective thing you can do to ensure that your money will last is to start out with a low withdrawal rate of 4 percent, then raise that amount annually to compensate for a cost-of-living increase or inflation.

The reason is that if a bear market hits early in retirement, an enormous loss can put such a big dent in the portfolio that it won't be able to recover in time to benefit when the market rebounds.

11. If you don't understand how an investment works, don't buy it.
There is no shortage of investment products out there. In addition to stocks and bonds, there are exotic hedge funds and insurance products.

Fortunately, you don't have to try and make sense out of them. In fact, you can construct a sensible portfolio with just two index mutual funds – one stock and one bond.

To reach your goals, you don't need to shoot for spectacular returns. Individual investors can outpace the market with moderately above-average returns in good times, as long as they don't lose too much money in bad times.

12. If you're not saving 10% of your salary, you aren't saving enough.
The earlier you start saving, the less you'll need to set aside every year to meet your goals. That's because you allow your money more time to grow -- the gains on your invested savings will build on the prior year's gains. That's the power of compounding, and it's the best way to accumulate wealth.

Saving at least 10% of your annual salary for retirement is recommended, but the older you start saving, the more you'll need to save. If you start at 50, you may need to put away 30% a year and still postpone retirement by a few years.

13. Keep three months' worth of living expenses in a bank savings account or a high-yield money-market fund for emergencies. If you have kids or rely on one income, make it six months'.
An emergency fund is a hassle to build, but you'll be glad you did next time your transmission sputters or your boss hands you a pink slip. Besides curbing spending where you can and setting aside a small amount of your pay every two weeks, there are several ways to build your cash cushion. Some sources to draw on:

• A bonus or financial gift from a relative
• Money you get back from a flexible spending account, a transportation reimbursement account or an insurance claim.
• An extra paycheck. If you're paid every two weeks, you'll get 26 paychecks a year. So in some months you'll get three instead of two. If your fixed monthly expenses don't change, you might be able to set aside one paycheck a year.

14. Aim to accumulate enough money to pay for a third of your kids' college costs. You can borrow the rest or use some of your income to help out when your child is in college.
Most parents have trouble saving enough for their retirement. But they still want to help their children pay for college.

In the struggle to feed your 401(k) and your child's 529, the 401(k) should win out. That's because there are no scholarships for retirement and your children have a lot of funding options, including financial aid, loans and a job. They also can go to an excellent, but less expensive school.

And when they're in college, if you have some extra cash after contributing to your retirement accounts, you can help them pay some of their expenses with it.

15. You need enough life insurance to replace at least five years of your salary – as much as 10 years if you have several young children or significant debts.
Life insurance lets surviving family members maintain something close to the standard of living they enjoyed prior to you or your spouse's death. Stay-at-home spouses also should have life insurance, since they do all sorts of things that you would need to pay someone else to do in their absence.

There are two types of policies:

• Cash-value: These cover you for your entire life and includes an investment component.
• Term: These cover you for a specific period of time and provide a death benefit only.

For most people the choice is a no-brainer - the premiums on a term policy are much lower.

16. When you buy insurance, choose the highest deductible you can afford. It's the easiest way to lower your premium.
It's the open secret of the insurance game: File a claim, your premiums go up. For that reason, it's in your interest – as much as possible – to shoulder small damages out of pocket.

For home insurance, raising your deductible from $500 to $1,000 could save you 25% on premiums, according to the Insurance Information Institute.

17. The best credit card is a no-fee rewards card that you pay in full every month. But if you carry a balance, high-interest rates will wipe out the benefits.
If you carry a balance, you may pay a variable interest rate as high as 19%. And if you've been late with payments or used up too much of your credit limit, you may be hit with a penalty rate, which can run north of 30%.

Credit card penalty fees, meanwhile, have been on the rise for years. The average late fee in 2005, for example, was $34, up 162% from $13 in 1995, according to the Government Accountability Office. Over-the-limit fees, meanwhile, were $31, up 138% from $13 during the same period.

So no matter how many airline miles or cash back rebates a no-fee rewards card offers you, it won't be enough to compensate you for your very expensive credit card habit.

18. The best way to improve your credit score is to pay bills on time and to borrow no more than 30% of your available credit.
It also helps to pay off debt rather than moving it around because the ratio of your credit card balance to your credit limit is key.

Say you owe a total of $2,000 on four credit cards, each of which has a $2,000 limit. Your total credit limit is $8,000, of which your total balance ($2,000) accounts for 25%.

If you transfer all your balances to two cards and cancel the other two, your total credit limit is reduced to $4,000, and your $2,000 balance now accounts for 50% of that limit.

Also, don't open new accounts when applying for a loan if possible.

19. Anyone who calls or e-mails you asking for your Social Security number or information about your bank or credit card account is a scam artist.
The scam artist's goal is to steal your money, steal your identity or both. In fact, don't carry anything with your Social Security number on it, and don't offer it to anyone unless it's for tax, employment or credit purposes.

There are other ways scammers and identity thieves can get your valuable financial information – for instance, by hacking into a merchant's system and lifting your (and hundreds of other customers') debit card pin numbers.

So be sure to monitor online bank and brokerage accounts a few times a week, and if you see any suspicious withdrawals or charges, report it to your financial institution.

20. The best way to save money on a car is to buy a late-model used car and drive it until it's junk. A car loses 30% of its value in the first year.
Don't believe your father's old-fashioned warnings about buying used. Buying a "pre-owned car" means you've let someone else drive those expensive early miles.

Do your research, of course, and look for a reliable model. But today's cars can generally be expected to rack up six-digit odometer numbers before experiencing major mechanical breakdowns.

Check ConsumerReports.com for detailed reliability information. Sites like Edmunds.com and Kelley Blue Book's KBB.com can help you narrow down the price you should pay.

21. Lease a new car or truck only if you plan to replace it within two or three years.
Keeping a car at the end of lease-term can cost you thousands more than it would have to simply have bought the car from the get-go.

Leasing does have its place, but it's not right for most people. If you're absolutely certain you don't want the car long-term, leasing keeps your monthly payments low. That's because the payments are based on the actual value the car loses during the time you're driving it. Instead of making payments then getting some money back when you trade the car in, as you do when you finance a purchase, with a lease you just don't pay that money out to begin with.

22. Resist the urge to buy the latest computer or other gadget as soon as it comes out. Wait three months and the price will be lower.
As with cars, electronics cost the most for those who must be first with the latest cool thing. Let the gadget freaks get their fill, then go shopping when the market has calmed.

Also, those first-in-line buyers can have the fun of discovering the annoying bugs, disappointing features and poorly designed interfaces. You can check the user reviews on C-Net and Amazon.com later to find out for yourself without having spent the money.

23. Buy airline tickets early because the cheapest fares are snapped up first. Most seats go on sale 11 months in advance.
Airlines would love it if every passenger would reserve their seat as far in advance as possible. That way, they'd always know how many flights they actually need for each route. So they make it as attractive as possible for people to book early. To punish procrastinators, ticket prices get higher as take-off gets closer.

Up to a point, at least. In the end, the airline just wants to fill every seat. So, if there are a few seats left open at the last minute, you can sometimes find a bargain deal. If you really have to fly, though, don't count on that. Airline bean counters have gotten pretty good at knowing just how many seats they need.

24. Don't redeem frequent flier miles unless you can get more than a dollar's worth of air fare or other stuff for every 100 miles you spend.
You typically need 25,000 miles for a domestic round-trip ticket. If the ticket costs less than $250, you're probably better off paying cash.

Airlines push redeeming miles online and will charge $5 to $15 to speak to a person. But it may be worth it: the airline representative has access to additional inventory on partner airlines.

Your miles stretch further on international flights, which typically require 40,000 to 60,000 miles or more depending on the destination. You want to aim to get $2 worth of airfare for every 100 miles. In other words, for a $1,200 flight to Paris, you'd be getting your money's worth using 60,000 miles.

25. When you shop for electronics, don't pay for an extended warranty. One exception: It's a laptop and the warranty is from the manufacturer.
Most electronics, like PDAs and MP3 players, have few moving parts that are prone to wear. If there's anything defective, you'll probably find out about it within the first few months.

Laptops, on the other hand, have parts like hard drives and big screens that can actually fail over time. Plus, laptops can cost thousands of dollars to replace.

Exchange-traded funds (ETFs): 5 smart strategies

ETFs: 5 smart strategies
Exchange-traded funds can cut your investment costs, lower your tax bill and simplify your life. Just make sure you handle them with care.

When Exchange-Traded funds, or ETFs, came on the scene in the 1990s, they looked like the rarest of new financial products - one that actually made money for you instead of just your broker.

The earliest ETFs emulated the Standard & Poor's 500 and other broad stock indexes. They were like traditional index funds, only better, offering the same one-stop diversification but with lower fees and tax bills.

As more financial advisers and small investors caught on to ETFs' advantages, the companies that issue them began expanding beyond major indexes to narrower slices of the economy such as health care and technology.

Again, the benefits to you were clear: Avoid the high management fees of sector funds and lower the risk that comes with picking stocks. It's no surprise that investment pros were soon calling ETFs the coolest thing to come along since, well, index funds, and predicting that ETFs would revolutionize the way you invest.

And then things went from cool to, like, crazy.

Not content to limit themselves to major market benchmarks, ETF sellers began churning out dozens of funds aimed at ever smaller market subsectors, including leisure and entertainment, networking and semiconductors.

The number of ETFs has ballooned from just 30 with $34 billion in assets six years ago to more than 200 today holding more than $300 billion. ETFs are quickly becoming a means of turning long-term index fund investing on its head, providing an easy way to make risky investments in whatever slice of the market happened to be hot five minutes ago.

Wanna invest in a nanotechnology or clean-energy ETF? You can -- although it's debatable whether you should. Ditto for that euro ETF you can buy if you believe that the value of the dollar will fall.

That doesn't mean ETFs are now so dangerous that they're only for the foolhardy. You can still cash in on their original promise if you ignore the hype and instead focus on how they might fit into your long-term investing strategy.

With that attitude in mind, here are five smart ways you can make the most of ETFs.

PLAN 1: Put a windfall to work

Payoff:Save a bundle on fees ETFs can be an excellent way to invest a large sum such as a 401(k) or IRA rollover, a bonus or some other windfall. Use ETFs for the portion of the money that you want to put into U.S. stocks, where ETF annual operating expenses are typically lower than those of comparable index funds.

Yearly fees for ETFs that give you broad exposure to foreign markets, on the other hand, are higher than what you'd pay for an index fund, while fees for bond ETFs and index funds are about the same.

One caveat: Because ETFs trade like stocks, you buy them through a broker, which means forking over a brokerage commission. That can eliminate ETFs' cost edge if you're making frequent investments or putting in small amounts.

PLAN 2: Create the "me" mix

Payoff: Diversify across all your wealth-producing assets With ETFs you can customize your asset mix in ways that used to be possible only if you built a complicated portfolio from scratch - or paid an adviser to do so.

Say you work for a financial services company that gives you stock options as part of your pay package. Between your salary and your options, you've already got a big piece of your future riding on the financial sector.

Instead of buying a broad market index that would give you even more exposure to the banking industry, you can assemble a portfolio of industry sector ETFs that duplicates the overall market while toning down or even eliminating its financial component.

Similarly, ETFs allow you to stress a particular investing style. If you're in or nearing retirement, for example, you might want more exposure to value stocks since they tend to be less volatile than shares of fast-growing companies.

In that case you might consider adding an ETF that tracks an index of value shares. Conversely, if you're a younger investor willing to assume more risk for higher returns, you could invest in an ETF that focuses on growth stocks.

Sound confusing? It needn't be. The ETF Allocator tool at the iShares website (ishares.com) will help you create a customized mix.
PLAN 3: Go a little farther afield

Payoff: A safer portfolio Diversifying beyond the traditional asset classes of stocks and bonds is a way to dampen a portfolio's risk. If you wanted more protection from inflation, for example, you could add an ETF that invests in natural-resources stocks or in TIPS (Treasury Inflation-Protected Securities), government bonds whose payments rise with inflation.

You can also gain an extra measure of protection by buying ETFs that specialize in areas that may be quite volatile on their own -- such as gold and emerging markets stocks -- but that can actually dampen a portfolio's swings since they often zig when the stock market zags.

If, on the other hand, you want to get more current income from your portfolio, you can buy an ETF that homes in on dividend-paying stocks or REITs (real estate investment trusts).

Here are some options:

For inflation protection, try iShares Goldman Sachs Natural Resources Index and iShares Lehman TIPS Bond.

For income, try iShares Dow Jones Select Div. Index and Vanguard REIT VIPER.

For still more diversification, try Vanguard Emerging Markets VIPER and iShares COMEX Gold Trust .

PLAN 4: Round out what you've got

Payoff: Higher returns with less risk ETFs make it easy to plug gaps in your portfolio. Say you own a lot of big-company stocks but nothing at the small end. You know that properly diversifying your investments lowers your risk and raises your returns, but you're not up to sifting through thousands of small shares, or even hundreds of actively managed funds.

By buying a small-stock ETF, you instantly get all the small-company exposure you need for a bit less than you'd pay for an index fund.

Conversely, if you're a small-cap enthusiast who figures you won't find many compelling bargains among the well-researched ranks of big companies, you can buy a large-company ETF to fill out your portfolio.

Even if you like investing in individual stocks, ETFs may be able to play a role in your portfolio.

If you pick individual large-cap stocks... ...buy Vanguard Small-Cap VIPER.

If you pick individual small-cap stocks... ...buy iShares S&P 500 index.

PLAN 5: Harvest a tax loss

Payoff: A big deduction come next April 15 ETFs can also help you do some tax maneuvering. Let's say you're sitting on a $5,000 loss in Dell shares but you still like the company's long-term prospects. You want to sell your stock to lock in the loss for the tax write-off, but you don't want to lose any appreciation in tech shares during the 31 days that the IRS "wash sale" rules say you must wait before buying back the stock.

Here's what you do:

You own a tech stock at a loss...sell the stock for the tax savings...buy a tech ETF...wait 31 days...sell the ETF...buy back the stock.

Walter Updegrave

An experienced investor is confident in his diversified stock portfolio

Get your bond fix - the easy way
An experienced investor is confident in his diversified stock portfolio - but where do bonds fit in?

NEW YORK (Money) -- Question: As aggressive savers and investors, my wife and I, who are 50 and 48 respectively, have accumulated a significant diversified portfolio of stocks. What we lack are bonds, and I have zero experience in this area. I put some money in a bond fund a few years ago, and it went down immediately. My wife and I are positioned to retire in five to 10 years, so I know we need some bonds to protect us in the event of a market meltdown. But I'm feeling intellectually paralyzed. Help! - Anthony S., Honolulu, Hawaii

Answer: I understand perfectly. When you were younger, so much younger than today, you never needed anybody's help in any way. But now those days are gone and you're not so self-assured. Now you find you've changed your mind, you've opened up the door.

Oops, sorry. That final plaintive plea at the end of your question hurled me into a Sixties time warp and suddenly I couldn't get the Beatles' "Help!" lyrics out of my mind. Not to worry, though. I'm happy to help you get your feet back on the ground - and your portfolio in shape for your looming retirement.

First of all, you should know you're hardly alone when it comes to being mystified by the workings of bonds. In many ways, the bond world is like looking through a Glass Onion where what we think of as economic reality gets distorted.

For example, most of us hate to see the economy go into recession. But the bond crowd, as the saying goes, likes a recession and loves a depression. That's because interest rates tend to fall in a stagnant economy. And since interest rates and bond prices are like two ends of a see-saw, falling interest rates mean rising bond prices - and rejoicing among bond investors (as long as companies and governments keep making those semi-annual coupon payments).

And then there are all those arcane terms: calls, premiums, discounts, coupon, zero-coupon, maturity, duration...it's enough to make you Cry Baby Cry.

Well, relax. There are plenty of ways to get the benefits you need from bonds without having to become a bond expert. That said, learning about how bonds work and what some of the lingo means never hurts. So before you do anything, I suggest you take a look at our MONEY 101 lesson on Investing In Bonds. You might also want to check out a bond site that, appropriately enough, is also called Investing In Bonds. Run by The Bond Market Association, the site has a lot of good tutorials and articles about bonds and plenty of data for people who want to get into the nitty-gritty of bond investing.

But let's Get Back to some specific Help! for you.

How much in bonds

Basically, between now and retirement you want to transition to a less volatile portfolio by dialing back the percentage of equities in your portfolio and increasing the amount in bonds. There's no specific figure for how much ought to be in bonds vs. stocks. But as a general rule, I'd say that by age 60 or so, you probably want somewhere between 40 and 50 percent of your portfolio in bonds.

As you age, you can then continue to increase your bond exposure, so that by age 70 your bonds represent 50 to 60 percent of your portfolio and by age 80 maybe 30 to 40 percent.

These are general guidelines. The figure that's right for you will depend on how much risk you're willing to take, what other sorts of resources you have (Social Security, other pensions, income from an annuity, etc.) and how much money you have (if you're really loaded and a short-term setback in the market won't seriously affect how much money you can draw from investments, then you can afford to be more aggressive, if you wish).

But the two most important things to remember are: first, you don't want to go into retirement with too aggressive a portfolio; and second, while there's a place for bonds in your portfolio leading up to and even after retirement, you still want to keep some of your savings in stocks in order to provide some growth to maintain the purchasing power of your portfolio.

Which bonds to buy

Okay, so what should you buy to get whatever amount of bond exposure you feel is right for you?

You could go with individual bonds, but generally that's a hassle and can be expensive unless you're investing, say, $50,000 or more. The exception is Treasury bonds, which you can buy directly from the U.S. Treasury, but even there I'm not sure it's worth the effort for most people, especially if you want to reinvest your bond interest payments.

So for most people I think mutual funds are the investment of choice for bonds. With funds, you could put together a portfolio of your own combining funds with short- or intermediate-term maturities that invest in government or high-quality corporate bonds and maybe even some high-yield bond funds.

But the easiest way to go - and a way I think makes good investment sense - is just to go with a total bond market index fund. You get virtually the entire investment-quality bond market in a single fund. And since you're buying an index fund, the annual expenses are extremely low, which is always a plus but particularly so for bond funds since higher expenses exert a bigger drag on bonds' generally moderate returns.

(For recommendations of specific funds you might consider, see the bond funds in the MONEY 65.

You don't have to pull off this move into bonds all at once. In fact, you're better off making the transition over several years. You can start by putting any new investment dollars into bonds. If it appears this approach isn't going to give you enough bond exposure by the time you're ready to retire, you can always start selling some of your stock funds and plow the proceeds into bonds. You can do this as part of the process of annually rebalancing your portfolio.

To the extent you can, try to confine these moves to tax-deferred accounts like 401(k)s and IRAs so the Taxman doesn't siphon off any profit on the sales. But if you must sell stocks or stock funds in taxable accounts, then look for opportunities to mitigate the tax bite by selling shares that will trigger losses or only small gains.

If you do all this over the next five to 10 years, I've Got A Feeling things will Come Together quite nicely and, financially at least, you'll be Free as a Bird in retirement.

Walter Updegrave

Look beyond the biggest stocks in the biggest markets

Time to see the world in a new way
International mutual funds can do a lot for you, but it's easy to head off in the wrong direction. Hint: Look beyond the biggest stocks in the biggest markets.

Until recently.

Nearly $130 billion has poured into overseas stock funds this year, more than five times the amount invested in U.S. equity offerings. A lot of that is just performance chasing, since foreign stocks have trounced domestic ones over the past three years thanks to faster overseas growth and a falling dollar.

But chances are you need to invest even more in foreign markets, and it wouldn't hurt to be a little more adventurous about it too.

Just as American tourists tend to flock to the familiar big names such as London, Paris and Tokyo, U.S. investors are sending almost all of their money to those markets as well. That's no way to really see the world - and it's no way to invest in it either.
Increase your stake

As recently as five years ago, many investment advisers recommended stashing just 10 percent to 20 percent of your stock portfolio in international funds. Most of us don't come close to that small amount. In a recent survey, for example, Fidelity found that two out of three of its 401(k) plan investors did not hold a single overseas equity fund.

That shortfall is especially worrisome today, when pros recommend putting 25 percent to 35 percent of your equity portfolio in foreign stocks. "The U.S. accounts for only half of the world's market capitalization," points out Anthony Ogorek, a financial adviser in Williamsville, N.Y. "And overseas economies are growing faster than in the U.S., so that's where the best returns can be found."

Foreign funds also give you a way to hedge against the U.S. dollar, since they hold companies that earn returns in overseas currencies. When the dollar is weak, as it has been lately, you get a boost when those returns are converted into U.S. greenbacks. The reverse is true when the dollar strengthens.

Look beyond large-caps

There is no question that large-cap overseas funds make great core holdings. By owning shares of huge multinational companies, these funds are a relatively safe way to play overseas markets, which is why they have become a staple of 401(k) plans. But if you stash your entire overseas allocation in large-caps, you won't get the full benefits of international diversification.

"In today's globalized economy, the financial markets of developed countries have become more closely tied than before," says Yale finance professor William Goetzmann. "So the stocks of big companies tend to perform in the same way, no matter where they're headquartered."

A U.S. money center bank such as J.P. Morgan Chase, for example, isn't all that different from Germany's Deutsche Bank. Both operate overseas, and they have similar reactions to global economic moves.

Moreover, if you restrict your international investing to large-cap funds, you will miss out on large swaths of the world's markets, as well as some of the best returns. That's because these funds invest the bulk of their assets in a few developed countries while holding little or nothing in emerging markets.

Get off the beaten path...

One way you can diversify beyond foreign large-caps, suggests William Rocco, a senior analyst at Morningstar, is to invest in a small-cap and midcap foreign-stock fund. These offerings mainly buy shares of companies with stock market values of $8 billion or less that trade in developed countries, although many invest a small stake in emerging markets as well.

Just as with U.S. small stocks, foreign small fry tend to grow faster than their large-cap siblings.

And because small companies typically get most of their sales locally, they are more closely tied to their country's economic growth than to global markets. That provides you with greater diversification.

Small-cap foreign funds are more risky than foreign blue chips, however, so put no more than 5 percent to 10 percent of your stock portfolio in one.

A top choice: T. Rowe Price International Discovery (PRIDX (Charts), which is on our Money 65 list of recommended funds. Recently the fund's top stakes included $2.5 billion Soitec, a French producer of silicon chips, and Financial Technologies, a $2 billion Indian developer of trading software.

...Or go even further

If you're the adventurous type, consider a diversified emerging markets fund, which holds the stocks of companies in developing countries. With these funds you have the potential for bigger returns - and bigger losses. It's not unusual for emerging markets to plunge by as much as 20% in a month, as they did earlier this year, before rebounding.

Invest no more than 5 percent of your equity portfolio in these funds. On our Money 65 list, we recommend SSgA Emerging Markets (SSEMX (Charts), as well as Vanguard Emerging Markets Stock (VEIEX (Charts), an index fund that is also available as an exchange-traded fund (VWO (Charts).

Once you have arrived at an asset mix that suits your goals, it's important to keep your expectations in check. Since overseas equity funds have had a tremendous run, chances are their returns will cool down, but no one can really say when. So be prepared to hang on.

And remember, experienced world travelers are ready to cope with any change in the climate.

By Penelope Wang, Money Magazine senior writer