Risk: Smart Strategies for Tricky Times

With the financial crisis shaking confidence in all kinds of investments, how can you protect your portfolio? Here are some tips from the pros

by Ben Steverman

Risk management officers on Wall Street with doctorates and sophisticated computer models couldn't escape the financial crisis that started last year. So individual investors might wonder what chance they have, especially as worries pop up in all sorts of unexpected places.

Some examples: Municipal bonds, ordinarily a boring and reliable investment, have been hit by the shaky finances at bond insurance companies. Even money-market funds, a popular and supposedly safe place to park cash, were found to be holding risky investments.

Meanwhile, stocks start the year 2008 by sinking ever lower, huge banks such as Citigroup (C) are forced to raise extra capital at high interest rates, and the place where all the trouble started, the credit markets, remains seized by fear of subprime mortgages and other toxic debt.

Due Diligence Is a Necessity

At a time like this, it might be a smart idea to give your investment portfolio a risk tune-up. We asked financial planners for advice on how to get under the hood and ask the tough questions: Where are the hidden risks in your investments? How do you position yourself in risky times? And, at a time when even muni bonds and money-market funds are being questioned, what's safe anymore?

Figuring it all out isn't easy. "These are unusual times," says Elaine Scoggins, a financial adviser at Merriman Berkman Next in Seattle. Investors "may need to do due diligence they haven't done in the past."

On Wall Street, much time and money is spent trying to limit risk, relying on complex trading strategies and esoteric derivatives and securities to limit the chance that an investment portfolio will blow up unexpectedly.

For many sophisticated firms, this didn't work. Why? For one thing, things have gotten so complex, "it's rendered prediction nearly impossible," says Mark Joseph, a financial planner at Sentinel Wealth Management in Reston, Va. The lesson for individuals? Keep it simple. If an investment can't be explained in a couple of sentences, you're probably taking on more risk than you understand, planners say.

Risk Management May Be Futile

Also, many argue the whole idea of managing risk is absurd. You "can apply all the algorithms and models you want," you're still trying to do the impossible, Joseph notes: predict the future.

You can't predict where and when risk is going to come from any better than you can predict the next disaster, whether it's a flood, earthquake, or nuclear bomb, says Barry Kaplan of Cambridge Southern Financial Advisors in Georgia. When a financial panic happens, "everyone heads for the door at once," trying to flee by unloading troubled assets. "No one's risk model has that built in," he says.

If you're nervous about hidden risks in your bond or money-market fund, financial advisers recommend you call up the fund company and ask tough questions. You particularly want to make sure these funds aren't holding subprime debt.

But subprime isn't the only threat. Bad mortgage debt may be the current risk on everyone's minds, but many other risks lurk out there, risks that no one has anticipated.

This realization—that risk is everywhere—terrifies some investors. Milo Benningfield, of San Francisco's Benningfield Financial Advisors, talks to many people who have kept their assets in cash for two years or more. "They're paralyzed," he says.

"No Risk, No Return"

But you can't avoid all risk simply by choosing super-safe investments. You may plow your money into Treasury bills, bank accounts, certificates of deposit, or a conservative money-market fund, but you could still be hurt by inflation, as the cost of living rises far faster than the value of your investments.