How Much Risk Is Right For You?

OCEAN CITY – After peaking in April at 11,205, the Dow Jones Industrial Average plunged below 9,800 in June — low enough to ignite talk of a bear-market signal. Even though past performance does not indicate future results, that recent retreat is serving to reignite the fears of investors who moved out of equities during the worst of the downturn — and who have shied away from investment risk ever since. Some view today’s high unemployment and a skyrocketing U.S. budget deficit as threats to the strength of the American economy and wonder whether the recovery will have legs. Others point to the market’s advances and retreats over the last year and question whether investing in stocks is worth the anxiety and effort involved. And so they remain on the sidelines — their portfolios heavily weighted in cash and fixed income.

While it’s impossible to predict exactly what will happen to the economy or financial markets in the immediate future, for investors with a long-term outlook (particularly those who may be 15 or 20 years from retirement, with time to weather additional market storms), the current environment could bring opportunities. "History suggests1 that the average 10- to 20-year period produces annual stock market returns of 6% to 12%," says Tom Latta, Managing Director of GWM Investment Management & Guidance at Merrill Lynch. "Because we believe in the growth of high-quality companies over long periods of time — and after seeing the S&P gain nothing during the past 10 years — you can make the case that better times could likely be ahead."

Latta and his colleagues have been urging investors to sit down with their financial advisors and reassess their portfolios in light of their risk profiles.

There are ways to help keep your investment strategy on track and take advantage of opportunities while also guarding against the risks of investing during volatile times.

1. Work your way back in. Rather than fret about trying to time the recovery, investors should consider positioning themselves for a long-term rising tide. "If you moved most of your assets to cash during the downturn, I believe it’s crucial to consider getting back to a diversified portfolio of equities, fixed income and cash that reflects your strategic allocation plan," says Latta. If you’re worried about near-term volatility, you could move back into the market gradually through a technique called dollar cost averaging,2 which calls for purchasing equal dollar amounts of an asset at regular intervals. "If you’re concerned about buying into equities at the worst possible point, this allows you to invest gradually over time across a potentially broad range of prices," Suri says.

2. Think globally. Investors looking to recoup bear-market losses might consider broadening their exposure to international markets, particularly emerging markets in Asia. "If you want to work your way back in and capture opportunities, those are the markets with great potential," says Latta. To tap that future growth, you might want to consider investing in both foreign companies and American businesses selling to consumers in international markets.

3. Consider defensive investments. While equity investments always carry a measure of risk, some sectors (including regulated entities such as utilities and consumer staples such as food and household items that people continue to buy regardless of the economic climate) may hold up better than others in an uncertain economy.

4. Explore downside protection. Qualified investors have long been able to take out options or access complex strategies to help limit the downside risk of equity positions. Another way to pursue many of the same ends: Consider allocating a portion of your portfolio that might otherwise go to equities to structured investments with principal protection at maturity. Debt securities generally issued by large financial institutions, these investments may be tied to the performance of a wide range of underlying assets, including a specific stock or stock index, like the S&P 500. They allow you to participate in any positive return generated by the underlying asset, up to a predetermined cap, while reducing the possibility that you will lose money in your investment, if held to maturity, and subject to the credit risk of the issuer. "They provide the ability to stay invested in the markets while reducing some of the risk," says Brian Partridge, Managing Director of Merrill Lynch’s Structured Investments Group.

5. Tap the tangible. Inflation may not seem like much of a possibility now, but experience has shown that’s not likely to remain the case indefinitely — which also means the current environment could offer an opportunity to buy inflation-indexed securities for the future at attractive valuations. Real assets — real estate, including real estate investment trusts (REITs), and industrial and agricultural commodities — are currently considered "cheap" and have historically benefited during inflationary periods, meaning they could increase in value as the economy recovers and inflation accelerates. Treasury inflation-protected securities (TIPS — government bonds whose principal adjusts upward if the consumer price index rises) could also be worth a look.

(A Merrill Lynch Wealth Management Advisor. She can be reached at 410-213-8520.)