Bear-Proof Your Portfolio

Question of the week:I've really gotten burned by the market over the last few years and I'm not very optimistic looking ahead. I'm tempted to cash out what's left and put it in CDs. What would you do if you were in my shoes? --Discouraged in SF

Dear Discouraged,

The great bear market of the last several years, coming so hard on the heels of the great bull market of the late '90s, has understandably left many investors gun shy. Despite this, I'd encourage you not to throw in the towel just yet.

We asked the Armchair Millionaire community for their perspectives on investing these days, and most comments revealed greater caution, but greater determination. Here are a couple:

"I have moved some money from more aggressive growth funds to more conservative funds, including value funds, and into bonds. But I still have a fair amount in the stock market and am continuing to invest via dollar cost averaging." --Karen C.

"If I had to do it over again, I would have included more conservative investments in my portfolio. I've continued to invest monthly (mostly growth and growth/income funds) over the last few years. My statements are depressing to look at, but I'm betting that my persistence will pay off." --Rondo

The theme in these comments? The bear market has taught these Armchair Millionaires to manage their risk more wisely.

You see, I believe a lot of the regret people feel right now comes from failing to appreciate the risk they were actually taking to get those terrific returns of the late '90s. So as you look ahead, it's important to know that you have a very important tool on hand--risk management--to help your portfolio ride out market swings. My checklist will help you get your bearings.

The Armchair Millionaire Checklist for Managing Risk

• Understand risk. Too often, investors think of "risk" as simply losing all their money. But it's more complex than that. If you own one particular stock, for instance, there are three major types of risk you face:
  • Company risk: the risk of that stock falling in price.
  • Industry risk: the risk of that stock's entire industry falling on hard times.
  • Market risk: the risk of the stock market as a whole dropping.
  If you own bonds (usually considered less risky than stocks), you still face risks:
  • Inflation risk: the risk of inflation eroding your returns over time.
  • Interest rate risk: the risk of changing interest rates affecting the price of your bonds.
  • Credit risk: the risk of the bond issuer defaulting.

• Know that nothing is risk-free. Even if you buy the "safest" investments of all--U.S. Treasuries--you still run very real risks. Your principal will be safe, but with low returns and the erosion of those returns by inflation, you risk not achieving your long-term goals at all.

• Know your risk tolerance. Risk tolerance is like pain tolerance. To make wise choices, you need a good idea of how much pain you can take if your investments drop in value. If your risk tolerance is low, you'll need to stick to more conservative investments that won't shift wildly in value. If you have a high risk tolerance, you can invest in more aggressive investments that will be more volatile.

• Diversify, diversity, diversify. Nothing works better to reduce risk than diversification. If you have a broadly diversified portfolio suited to your situation that includes domestic and international stocks, stocks with large, medium and small caps, and possibly a range of bonds, you'll buffer some of the market's day-to-day volatility. Mutual funds, because they own a number of stocks and/or bonds, are an easy way to diversify.

THE BOTTOM LINE: If you want the highest returns over time, accept the risk that goes along with those investments. If you can't take the heat, stick with lower-risk investments--but be prepared to have lower returns.