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The Fed-Proof Portfolio

In two weeks, Ben Bernanke will try to fill the shoes of the venerable Alan Greenspan as Federal Reserve chairman and begin to shape policy for the largest free market economy in the world.

What does this mean for interest rates, your portfolio, the economy's health, the housing market, the payment on your Lexus GS400, and the world as you know it? Well, as the advisor of the Fool's dividend-stock newsletter, Motley Fool Income Investor, I've been asked this question a few times recently. So I think it's best to take a stab at answering it here.

The truth is that it's been 18 years since we've seen a changing of the guard at the Fed, so few know exactly what to expect. But that said, the answer to this question is that it doesn't mean a whole heck of a lot.

On Dec. 13, 2005, the Fed hiked interest rates by another quarter point. And virtually all the powerful minds in the powerful places of the world believe that they're going to keep right on raising them for at least the first half of 2006. What can you do about that? The same thing you were hopefully doing yesterday: Build a portfolio that will stand against all markets, economies, and interest rate cycles -- one that, when all is said and done, should fare better than any other portfolio.

At this point I know you're probably saying, "Gee, is that all? Why didn't I think of that? Thanks, Mr. Rocket Science, but that's easier said than done." I understand the sentiment, but it's actually easier said and done.

Many seem to want to "position" their portfolios for the next phase in the market. They want to tinker with their holdings to prepare for the next wave. But you can accomplish your long-term goals far more effectively by amassing a portfolio of tried-and-true, dividend-paying stocks and staying the course.

The dividend conundrum
I realize this might surprise some folks. After all, many of the highest-yielding stocks are often clustered in sectors -- such as financials, utilities, and real estate investment trusts (REITs) -- that are traditionally viewed as being more sensitive to changes in interest rates. You have to look no further than the early cycle price dips in companies such as Bank of America (NYSE: BAC  ) , Southern Company (NYSE: SO  ) , and Equity Office Properties (NYSE: EOP  ) to see this phenomenon in action.

And while this can certainly be true, my point to you today, again, is not that dividend-paying companies are the best stocks to own when interest rates are rising. It's that they're the best stocks to own in any environment.

You have to remember that few traditional investments respond favorably to higher interest rates. They're just not a good thing (unless you're simply trying to earn higher rates on your cash balances). But dividend-paying companies have that little feature that tends to balance out this negative: They pay cold, hard cash that can be pocketed or reinvested in additional shares, often at even more attractive prices.

Be proactive, not reactive
Consider that the sectors I mentioned above are typically the ones that pay dividends. And as I've indicated in past articles, we know that dividends can lead to more powerful investment gains over time than any other tool in your arsenal. They simply allow you to beat the market while taking less business risk, and because of that, we're unwilling to forgo them. We also know that it can take time for a dividend-reinvestment strategy to put forth all its strength. And finally, we are well aware that no one -- and I mean no one -- has been able to successfully augur the short-term movements of interest rates.

Thus, we know that we must have dividends. We know we must invest for the long term. And we know we can't trade in and out of our positions based on short-term shifts in interest rates since we can't consistently predict them. Therefore, we have no choice but to prepare ourselves as best we can for any rate environment and willingly ride out the short-term gyrations.

Fortunately for us, that single choice is also the best choice. And over time I firmly believe it will generate remarkably consistent and powerful results for your portfolio.

If you're looking for dividend-paying stock ideas that will help you build a Fed-proof portfolio, consider a free trial to Motley Fool Income Investor. A trial will gain you immediate access to more than 50 recommendations that are collectively beating the market and providing an average yield of 4.6%. There's absolutely no obligation to subscribe, and the past picks are yours to keep no matter your decision.

Mathew Emmert tries to help folks invest both Fed- and anxiety-free. He owns none of the companies mentioned in this article. When he's not playing "Trivial Pursuit," he's the advisor of Motley Fool Income Investor. Bank of America and Southern Company are Income Investor recommendations. The Fool has a Fed-proof disclosure policy.

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