Risk: Smart Strategies for Tricky Times

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Like "no pain, no gain" in the health club, "no risk, no return" is a basic principle in the financial markets. The key, advisers say, is taking on the sort of risk that actually will let you prosper in the long term.

In return for putting up with the aggravation of volatility, a diversified portfolio should perform well over the long term, says Frank Armstrong, president of Investor Solutions, an investment adviser and manager in Florida. Thus, taking on extra risk for more return is particularly smart if you won't be needing the money for decades.

However, Armstrong adds, avoid at all costs "uncompensated risk," the risks that are unnecessary and won't pay off in the long run. These hidden risks—for example, concentrating a portfolio on too few of the same kinds of investment—will hurt performance over the long term. As Benningfield put it: "There's nothing wrong with risk. It just has to be calculated risk."

We asked advisers for tips on how to keep risk to a minimum while still boosting returns. Here are several of their ideas:

1. Watch those expenses. The fees that fund managers take every year cut into returns, but they also can encourage fund managers to take on extra risk to justify their costs. The financial crisis has made investors especially suspicious of fund managers. A fund's "name often has no bearing on what happens in the fund," Joseph says. Read prospectuses carefully, call up fund companies if you have questions, and move your money elsewhere if you're not satisfied the fund—whether it's a money-market, bond, or stock fund—will stick to its objectives and risk profile. That's why many advisers recommend index funds, where the investments are automatic and the fees are low.

2. When it comes to municipal bonds, you can relax. Bond insurance may be in trouble, but the bonds themselves are backed by state and city governments that are very unlikely to default. Look carefully at what kind of bonds you or your fund are holding, but the vast majority of munis should be O.K. (BusinessWeek.com, 12/20/07), advisers say.

3. Diversify. If your investments are diverse, you're maximizing your returns while minimizing the risk. Unless you take on some risk, you can't expect any return over the long term. Key ingredients of any diverse portfolio are international stocks, and some say alternatives like commodities should be added to the mix. Even especially risky investments are O.K. in moderation, as long as they are one part of a broader strategy. "You have to look at how it fits into the overall portfolio," Kaplan says.

Also, be careful not to unintentionally concentrate your portfolio in dangerous ways. Kaplan says three years ago an 80-year-old widow came to him with a portfolio of large bank stocks, real estate investment trusts (REITs), cash, and bonds. Each part of the portfolio looked conservative and safe by itself, but together it was a disaster waiting to happen. The same financial crisis and housing downturn that hurt banks has also hurt REITs and many bond funds.

Advisors urge investors to look carefully at funds to make sure they don't overlap. No matter how many mutual funds you hold, they don't provide extra diversification or protection if they all hold similar stocks in the same industries.

4. Watch out for high-yielding bonds or other investments. Some yields are "suspiciously high," raising questions about the reasons, Benningfield notes. "If you're an investor and stretch for yield, you're likely to have a portfolio that you don't understand," says Armstrong.

5. Equities are for risk; bonds are for safety. If you want to boost risk in your portfolio, and thus your chances for return, most advisers say you'll get a better return by betting on equities than bonds. Bonds are there to protect your capital, not provide growth.

In turbulent times, the individual investor is at the mercy of market forces far beyond his or her control. But advisers say that a little extra research, along with perhaps some professional advice, can help investors uncover hidden dangers while they seek as much risk and return as their nerves can handle.

Steverman is a reporter for BusinessWeek's Investing channel.