Hamish McRae: What's a poor investor to do when houses, bonds and shares are dogged by the bears?

What should investors do with their savings? First, they must have some. For many people - faced with the prospect of higher mortgage payments, council taxes, fuel prices and so on - the most sensible thing to do is to spring-clean the household finances. Any spare money should go on paying off high-interest credit card debt and building a cushion of cash to cope with these rising charges. Only after that should people think about long-term investment.

What should investors do with their savings? First, they must have some. For many people - faced with the prospect of higher mortgage payments, council taxes, fuel prices and so on - the most sensible thing to do is to spring-clean the household finances. Any spare money should go on paying off high-interest credit card debt and building a cushion of cash to cope with these rising charges. Only after that should people think about long-term investment.

Still, many people are setting up self-invest pension funds on the grounds that they cannot do worse than Equitable Life - and if they do, they can blame only themselves. Meanwhile, the surge in house prices has opened the door to trading down and releasing some of the cash tied up in the home

Now the problems begin: at the moment, no investments appear terribly attractive. Buy UK property and let it out? That is unlikely to be the gravy train it once was. Half the economists are convinced that home prices will fall and the other half don't expect them to rise much. Buy UK shares? Prices have bounced back strongly from the bottom a year ago, but, arguably, much of the recovery has now happened. Some people judge that world share prices (and, to a lesser extent, UK ones) are already overvalued. Bonds? Safe ones, such as gilts or those of top companies, have low yields and in any case are vulnerable to fears of rising inflation.

Even sophisticated investors find themselves in this bind. Some parts of the world, such as the emerging markets of Eastern Europe, India and East Asia, have done well. But while their performance may continue to be excellent, making money by buying securities there has become harder. Take India. Bombay was one of last year's best markets, but it has flattened in recent months and there is no longer the sensation that India's boom is underpriced. As for China, concerns surroundits leaders' ability to check the boom without damaging longer-term growth.

So what do the professionals say? Naturally, they have a spectrum of views, from those who feel that shares still offer value, thanks to companies' ability to deliver rising profits, to those who see a second leg to the bear market. I have just been looking at two views that seem particularly interesting.

One comes from Morgan Stanley. It looks at the implications for UK shares under three house-price scenarios. Its economists reckon that prices are 30 per cent overvalued but that this does not necessarily mean the property market will crash. The investment team's best judgement is that the market will have a "soft landing": prices will stop rising much but they will not fall.

It points out (first graph) that prices have fallen only twice since 1950, both times during recession. An example has been set in the Australian and Dutch housing markets, which have had soft landings. And the Bank of England has built up a good track record at monetary policy. It should be able to manage interest rates so that growth in consumption slows down without triggering a crash. The team finds it hard to see what might cause a crash. A policy error by the Bank, or recession, could happen, but neither seems likely.

On the other hand, Morgan Stanley is canny enough to acknowledge that it might be wrong. So it sketches the possibility of continued double-digit housing inflation, and also of outright deflation; then it thinks through what the effects might be on the economy.

The first assumption is a good one and will comfort homeowners and, to some extent, home buyers. Price stability lets people make rational choices about where they want to live, how much they want to spend on a property, how they plan their lives more generally. The windfall gains to property owners are distorting and, insofar as they distort people's savings and investment plans, they damage the economy. So let's hope Morgan Stanley is right.

And if it is wrong? The last time house prices fell, in the early 1990s, shares in tobacco, alcohol, banks and hotels did best; shares in property, housebuilders and retailers did worst.

Some other banks are less optimistic about the soft landing. ABN Amro thinks the bubble will get bigger and that low inflation will inhibit the Bank's ability to prick it by raising rates, increasing the risk of a hard landing in the medium term.

What about the general level of shares and in particular the relative attractiveness of shares vis-à-vis bonds? The second interesting viewpoint comes from a British boutique consultancy, Longview Economics. It thinks that US equities are 25 per cent overvalued but that shares still carry much lower risks than bonds. It has built an econometric model that measures over- and under-valuation and applied it to US shares going back 50 years. The results are shown in the second graph. As you can see, shares are not as hugely overvalued as they were in 2000. Nevertheless, Longview's model does show a significant overvaluation and it notes that in the past this would have pointed to a fall in share prices of 10 per cent or more. It thinks this is possible over the next 18 months but that at the moment it is unlikely given the unattractive returns on competing assets, bonds and cash.

For professional investors, this makes sense. They have to hold one of those three main assets and rationally they should hold the least unattractive. But this is hardly a ringing endorsement.

From a UK perspective, it gives more comfort, for valued on price/earnings ratios, UK shares are 20 per cent undervalued vis-à-vis US ones. As the UK market offers at least as much international exposure as the US one - half the profits of the FTSE 100 companies come from abroad - it would be rational to expect further modest gains.

What does this do, though, for ordinary British investors seeking to preserve wealth? A couple of thoughts. One is that the general rule of spreading investment risks is always a good one. People should try to balance the need to live somewhere with a portfolio of savings. The bigger the spread, the safer it is. Since most people's largest single asset is the house they live in, and that is inevitably a lumpy investment, a lot can be said for spreading the rest somewhere else.

The other is that the biggest single determinant of investment success is taxation. The ability to put money into a pension pot free of tax gives the UK taxpayer an immediate uplift relative to saving out of taxed income. The rules are changing in a couple of years, giving much greater freedom in the amount people can invest. Anyone wondering what to do with spare cash would be wise to look at these changes before making any irrevocable decisions. Alternatively, they could always spend it.

Love's labours are not lost if you're flexible

I read a wonderfully cheering story in the property section of - where else? - The Independent last Wednesday. It carried a real lesson in practical economics.

A reader and his wife live in South Wales and have just become pensioners. He worked as a labourer and his wife, who came to Britain from a small village near Naples when she was 21, worked as a cleaner in a hospital. They had never earned very much money but had managed to save enough to buy a house in the docks in Newport. It was in bad condition but he had done a lot of work on it and it was worth about £70,000. His wife's dream was to return to Italy and he wondered, given that they had only a limited amount of money, if they could afford a property there.

Well, the paper's House Hunter column found three delightful properties well within the budget and it was clear that the couple could have a really prosperous retirement.

There are at least three lessons here.

One is that people on modest incomes can, if they save money, acquire assets and manage their lives sensibly, retire with a fine lifestyle.

The second is that to take advantage of this state of affairs you have to be flexible. In this case the reader was prepared to renovate a house and then move country ("whatever makes my wife happy is fine by me"), but for other people the choice may be being posted abroad, changing jobs or careers here, or moving to a different part of Britain.

And the third is that the benefits of being Europe's fastest-growing large economy can spread out in practical ways right across the country. It is not just the honey pot of the South- East or the young professionals who can benefit. People at the top of the pile often ask whether economic growth is worth chasing: who wants a new BMW? Of course, the rewards of growth are capriciously distributed, but it is good to see wealth moving through society and bringing happiness with it.