NEW YORK (Money Magazine) - A few years ago, many of us defined risk as missing out on the next great opportunity -- a red-hot tech stock, say, or a sought-after IPO. After so many years of a climbing market, stocks seemed like a sure thing.
They weren't, of course, but many of us didn't recognize that until we felt the sharp edge of true risk: losing large amounts of money.
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Now it seems we've come full circle. Investors are fleeing stocks and rushing to the perceived safety and security of bonds. And they're also chasing performance -- year-to-date, the Dow Jones corporate bond index is up 7.6 percent versus a decline of 18 percent for the S&P 500.
But consider this. What if buying bonds now is like buying stocks was in the late 1990s? What if we're just setting ourselves up for a fall? There's a word for that on Wall Street: whipsawed. It's what happens when you buy a top-performing asset just as it tumbles, then bail out with losses only to reinvest in something that is also about to peak, giving you losses anew.
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We're not suggesting that you should purge bonds from your portfolio. Diversifying among asset classes is still key to controlling risk in a portfolio, and trying to time the market is a losing bet.
But we are urging a candid assessment of the risk/reward profile of everything that you own: What is your upside expectation? What is your downside exposure? How do the different pieces of your portfolio fit together? As you undertake this examination, we offer three observations of our own.
1. Your "safe" investments may be riskier than you think.
A growing chorus of market strategists believes that rushing into bonds is a risky bet these days. Explains Morgan Stanley senior market strategist Byron Wien, "We know it's the wrong time to get into bonds when we're seeing record amounts of money flowing there."
Bond prices fluctuate based on interest rates. The lower rates go, the more valuable existing bonds become. That's what has happened over the past year as Alan Greenspan and the Federal Reserve drove down the federal funds rate to try to spur the economy.
But how much lower, practically, will interest rates fall? At 1.25 percent, the federal funds rate is the lowest it has been in 41 years. It may go a bit lower, but the degree of positive leverage available to bond investors is very small.
And what if interest rates should rise instead? Many of the historical drivers for higher rates have been switched on in the past year: tax cuts, increased government spending on defense, higher oil prices. That does not mean rates will automatically shoot up in the next 12 months, but it does increase the odds that -- whether in 2003 or 2004 -- the direction of interest rates could very well shift. And that would be bad for bond prices.
Of course, bondholders need not sell even if prices do decline. Investors in individual bonds can always hold their bond to maturity, guaranteeing that they get their principal back (provided the issuer remains solvent). But depending on how many years remain until your bond matures, you could face a lengthy period of below-market (and potentially below-inflation) returns.
It can be far worse for bond fund investors. That's because a fund has no maturity date when the return of your principal is guaranteed. Instead, you are at the mercy of your fund manager and how he or she manages an entire portfolio.
Back in 1994 -- the last time interest rates spiked unexpectedly -- the average bond fund lost more than 4 percent, and many of the funds were hammered with double-digit declines. Those that had stretched for yield by buying exotic fixed-income securities were particularly vulnerable to rising rates. The Piper Jaffray Institutional Government Income fund, for instance, dropped a stunning 28 percent in 1994.
2. Your "risky" investments may be safer than you think.
Now let's talk about stocks. Bears argue vehemently that it's still not a good time to invest in stocks. They note that corporate spending has yet to pick up and that the economy could get hurt from a rise in unemployment, an oil price shock or heightened terrorism.
Those scenarios are very real. But that doesn't mean the risk/reward profile of equities hasn't become a whole lot more enticing -- especially given the perils facing the bond market. As Wells Capital Management chief investment officer James Paulsen notes, "Evidence of great risk is really disguising the seeds of a great investment opportunity."
Stocks have historically outperformed every asset class over long periods of time. That's because, unlike bonds and cash, stocks offer the potential to grow along with the economy. If that weren't reason enough to consider stocks, both inflation and interest rates are at historically low levels. On the one hand, that makes it cheaper for businesses to operate, improving their efficiency.
But it also makes stocks relatively more appealing for investors -- if 10-year Treasuries are paying just 4 percent, you need only modest earnings growth to have a reasonable chance of better returns.
Finally, corporate earnings are better than newspaper headlines might lead you to believe. According to a mid-October report by Salomon Smith Barney equity strategist Tobias Levkovich, of 191 S&P 500 companies that had reported earnings, there were six positive earnings-per-share announcements for every negative one (that ratio was 5 to 1 in the year's second quarter).
But it's not just quantity that matters. According to Thomas Loeb, co-manager of the Vanguard Asset Allocation fund, the quality of earnings has also been getting better. He argues that corporate cash flows have been improving, thanks to inventory reductions and that the trend translates into a favorable earnings outlook for stocks. Loeb has put his money where his mouth is: Earlier this year, he shifted his fund from its usual 65 percent/35 percent stock/bond mix to 100 percent stocks.
Most important, though, is the status of stock valuations. With a bear market now deep into its third year, stocks are no longer priced for perfection. That doesn't mean they are poised to soar immediately, but it does mean that the relative level of risk stock investors are taking today is an order of magnitude smaller than the risk they were taking in early 2000.
3. Cash is more important than ever.
With bonds facing new risks, cash may take on new strategic importance. For growth investors, cash offers a safer way to buffer stock portfolios. It also affords easy liquidity, so you can quickly and cost-effectively take advantage of buying opportunities in the stock market when they present themselves. Growth investors might consider scaling back on bond positions and making larger-than-usual allocations to cash.
For income investors, cash offers solid security. In today's low-yield environment you may feel the need to stretch the risk profile of your investments to generate the income you need. That risk can be balanced by risk-free positions in money-market funds. If interest rates rise, money fund yields rise with them without putting principal at risk. Here rising rates help your return.
For each of us, then, cash offers a flexibility that can prove advantageous in dealing with today's market conditions. That makes cash-management and cash-investment strategies more important than ever.