Stocks Aren't as Risky as You Think

The fact that the S&P 500 is still trading 11% off its highs of last October has reminded everyone about the risk of owning stocks. Going forward, however, stocks don't seem as risky -- especially when you compare them to the alternatives.

You've seen firsthand the way stock prices can fall. Just so far this year, Humana (NYSE: HUM  ) has dropped 36%, while former highflier Crocs (Nasdaq: CROX  ) has lost more than 70% of its value. When the bear is roaring, the stock market can seem like a minefield, with plenty of companies like Kona Grill (Nasdaq: KONA  ) announcing disappointing results.

Risk is relative
While everyone's talking about the risks to your stock portfolio, you're not hearing as much about the risks of holding other types of assets. But that doesn't mean that those assets are free of risk. Consider the following alternatives to stocks:

  • Cash. With markets falling, cash has been king again. But with Treasury bills earning less than 2% and CD rates hovering around 3%, holding cash comes at a cost: Since you're not even keeping pace with inflation and taxes, your cash reserves are slowly losing purchasing power.
  • High-grade bonds. You can get a little more income from bonds, as 30-year Treasuries are yielding 4.5%. But after a bull run in bonds that has lasted more than 25 years, it's questionable whether interest rates can go much lower. Just in the past month, long-term rates have risen about half a percentage point; long-term bond funds like the iShares Lehman 20+ Treasury ETF (NYSE: TLT  ) dropped 5% in response. A more significant rise in long-term rates could seriously hurt bond fund investors.
  • Junk bonds. The credit crunch has made junk bond yields more attractive, as spreads over Treasury rates have widened. But on top of the same interest-rate risks that high-quality bonds have, you also face default risk. With bankruptcies among sectors like airlines on the rise, you can't discount the potential of losing a substantial portion of your investment in junk bonds.
  • Precious metals. Gold and silver have been on a strong run, with gold tripling since 2001. Silver quadrupled in price between 2003 and its recent highs. Yet since their peaks just over a month ago, gold has dropped 13%, while silver is down 20%.
  • Commodities. From energy to grains, commodities prices have soared in recent years, and some are still performing strongly. However, wheat prices have fallen nearly 40% since March, and soybeans are down about 18%. Stocks that follow commodities and metals have been equally volatile, as the following chart shows:

Stock

1-Week Change

Potash Corp. (NYSE: POT  )

(15.5%)

Freeport-McMoRan (NYSE: FCX  )

(6.7%)

Mosaic (NYSE: MOS  )

(15.8%)

Embrace risk
None of this is to say that stocks aren't risky. They are. But avoiding stocks entirely doesn't solve the problem.

To be a successful investor, you have to take risk. But with that risk comes the potential for huge rewards. By understanding the relationship between risk and returns, you can make long-term investments that are likely to be extremely profitable.

More on why you can't ignore stocks as an investment:


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