My 2011 forecast was not too shabby for stocks: US stocks were flat, but better than the rest of the world's stock markets. Europe sunk about 10%, and emerging markets dropped about 15%. There was not much variation within those averages; everyone struggled. For debt, I was dead wrong. Bonds provided better returns than I predicted, as US interest rates kept falling. And the longer the maturity, the better the performance. As predicted, commodities were volatile, including gold. After being up more than 30%, gold has dropped like a less-than-precious rock (about 10% in a few days).

Some of the investment heroes of recent years offer a salutary reminder of why you might hesitate to make huge bets based on your predictions. Bill Gross, who runs the PIMCO bond funds, predicted that Treasury bonds would drop and PIMCO sold them early in the year. Unfortunately, Treasuries continued to rise. PIMCO trails the benchmark by about 5% this year, a huge amount in the bond world. John Paulson, who made a bundle from the collapse of the housing market, made big bets on financial stocks and China. According to Bloomberg, one of his largest funds is down 45% through November.

These two investors will be heroes again, but I mention them now as a reminder that making all or nothing bets can have large consequences for your portfolio return. Like Mr. Gross, I think Treasuries are too expensive, but my suggestion is to reduce your allocation by a percentage. If you normally have 20% in bonds, you might reduce that to 15%, or 10% if you're feeling frisky. It's when you feel you have the world figured out that you should exercise a little caution.

If I told you that a certain government ran up huge deficits, and appeared to have no plan to work toward a balanced budget, you would probably suggest that I avoid that country's bonds. And yet here we are in the US, with 10-year interest rates at 2%. Investors seem to be ecstatic to lend to just such a government.

In my opinion, that's less a vote of confidence in a well-oiled government than a statement about the alternatives. Investors used to be ecstatic about European government bonds, too. A year ago, 10-year Italian bonds yielded about 4.5%; the government recently had to pay 7% to get anyone to buy those bonds, and even at that rate, investors seem squeamish. How quickly things change. I hope someone in Washington is paying attention. Investors are willing to accept low yields until all of a sudden they aren't. As a Financial Times article noted, the danger is when investors think they've invested in something safe, and they stop thinking. Everything has a risk attached to it; we should keep our brains working, even for supposedly safe investments.

It should be no surprise, then, that I'm skeptical about the future returns of US bonds. I've been saying this for a few years now, and bonds have continued to deliver positive returns. I prefer to think I'm early rather than wrong, but that's for you to decide.

Stocks are the better investment if you're thinking anything beyond a year or two. Stock prices are likely to jump up and down for a bit longer, as they did in 2011, but if you can ignore that volatility, the probability of solid returns is very good. And while we wait, we get dividends that are bigger than what we could get from bond interest payments. Dividends aren't as secure as interest payments, but we're investing in strong companies that should be able to pay dividends even in difficult times.

In 1999, people asked why anyone would own bonds. All you needed to do was own stocks for the long term, and we all invested for the long term (didn't we?). In 2012, people are asking why anyone in his right mind would ever own stocks. Bonds are best; it's obvious. Any guesses on what I think people will be saying in 2025?

Within the US market, expectations for large companies are wonderfully low. Yes, you read that right. Low expectations are a wonderful thing, because stock prices reflect expectations. Analysts expect 5-6% earnings growth rates at many large companies. That's why those stocks aren't nearly as expensive as they were at the end of the 1990s, when expectations ran high. Setting low expectations is like setting a high-jump bar a few feet off the ground: even a mediocre jumper can clear it.

Stocks in Europe could have a tougher time than those in the US. Euro countries appear to be moving toward a tighter fiscal union, but many hurdles remain. All that confusion is likely to keep spending and investment at low levels. I think all minds are now aware of the severity of the Euro problem, so I expect Europe to keep working toward a solution. As in any democracy, when all the choices are less than palatable, policy makers will put off decisions for as long as possible. Winston Churchill said about the US that it would eventually make the right choice, after it exhausted every other alternative. Most democracies are no different.

With troubles in Europe and slow growth in the US, developing countries are unlikely to have a wonderful 2012. Brazil's growth rate, for example, has slumped from 6% down to nothing. Developing countries need a healthy Europe and US in order to keep growing.

Because the future has a habit of surprising, I advise that you retain a diversified portfolio, and deviate from your long-term asset allocation only when you have a strong opinion.

Sources: Schwab, Wall Street Journal, The Economist, The Financial Times

And now, for the 2012 forecast:

Based on a Price to Earnings (PE) ratio of about 13, a bit below the long-term average, US stocks look like a decent value. We have a tangle of issues to deal with in 2012, which probably means sizeable swings in stock prices. But if your time horizon is anything beyond an election cycle, I think you'll be happy that you own stocks. Returns for 2012 should be in the -10% to 10% range.

European markets were down again in 2011, on average about 10%. Given all that's going on with the Euro and the European Union, stock prices are likely to swing even more wildly than in the US. By the end of 2012, I expect a return in the -15% to 5% range.

Emerging markets fell even more than the US and Europe. The emerging markets index dropped about 15% in 2011. The famous four, Brazil, Russia, India, and China, all suffered. I think it's OK to own international stocks, but I wouldn't weight them too heavily in your portfolio. Returns here should also be in the -15% to 5% range.

Bonds performed well in 2011, and the longer the maturity, the better the performance. This is exactly the opposite of what I counseled a year ago. Short-term bonds gave you 2-3%; intermediate bonds returned 8-10%; and long-term bonds returned a whopping 25%. So what do I predict for 2012? Nothing's changed, except that prices look even more stretched. I think there's a good chance bonds could lose money – especially intermediate and long-term bonds.

Municipal bonds performed well in 2011, up about 8-9%, with most of that return coming from price appreciation rather than interest. Municipal bonds had been beaten down in 2010, so a bounce back makes sense. I think municipal bonds continue to be a decent investment, primarily for those in higher tax brackets.

Commodity prices have been volatile, as investors bet on either healthy demand or a nasty recession. Short-term traders love volatility. The rest of us should steer clear. Several years ago, buying commodities might have been a useful way to hedge against inflation risk. Buying commodities now looks more like placing a bet at a casino.

Publicly-traded real estate gained a few percent in 2011. Apartment REITs will probably do best in 2012, but tight credit should keep a low cap on returns for all REITS. I would not be surprised to see losses in this group, perhaps in the 5% range.

I still like stocks for the long-term investor. You can own good companies that pay solid dividends, and that are likely to increase in value over time. You have to pay the price of anxiety to own stocks, though. Price swings come with the purchase. To offset the risk and volatility, investors should diversify their portfolios with other assets, such as bonds, real estate, and commodities. For 2012, you might hold a bit more cash than usual. But don't get carried away. The returns from cash are paltry. As always, I suggest investors maintain a balanced asset allocation and try to keep costs down.

Sources: Economist, Value Line, Vanguard, Financial Times, Bloomberg.