In the great battle between fear and greed, it's greed's turn to shine. But how long will the rising tide of the stock market rally keep raising the value of everyone's investments -- and will you be ready when the waters start to recede again?
It's still out there
Risk is a difficult concept to wrap your head around. It's easy to see in hindsight; once bad things actually start happening, you can look back and understand what factors and events set the stage for what would eventually follow. And even during good times, you can look back at history and see the cycles of investments going in and out of favor.
But at some point, if risks don't turn into actual problems, then it becomes all too easy for most investors to discount them or even stop thinking about them entirely. Those who continually warn of potential problems with investments have to deal with the very real possibility of being perceived as permanent pessimists and therefore ignored.
So as the rally continues past the one-year mark and the S&P 500 goes over 1,200 for the first time since September 2008, you might be tempted to write off the 2008 market meltdown as a one-time event that will never be repeated. Yet that would be the wrong lesson to take from those painful times that many of us would just as soon forget.
How to invest in a risky world
In my view, the best way to walk the fine line between risk and reward is to take a more conservative approach, especially as you get older and closer to retirement. When you're young, you can afford to make brash moves without fear that you're putting your entire life savings at risk. Later on, though, you simply don't have the time to recover from major mistakes.
Conservative, however, doesn't mean stock-free. You just have to look for the right stocks. There are several strategies you can follow.
One is to invest in defensive stocks that will perform relatively well even in down markets. During 2008, when the S&P dropped 37%, Wal-Mart (NYSE: WMT ) , McDonald's (NYSE: MCD ) , and General Mills (NYSE: GIS ) all weighed in with positive returns. Wal-Mart's business model is tailor-made for recessions, while McDonald's and its value meals catered to recession-hit families. And since people always need to eat, General Mills was able to make it through the bear market largely unscathed. Each of these companies focused on necessities rather than luxury items, which served them well in a tight economy.
The trade-off of owning defensive companies is that you won't often see stellar returns during good times. None of the three companies discussed above were anywhere near the top of the performance leaderboard in 2009. But over the long term, you can hope for a smoother ride than you'll get from volatile growth stocks.
The 2008 bear market also shook some beliefs about market correlation. In past downturns, foreign stocks were sometimes a safe haven even while U.S. stocks suffered. But this time, stocks around the world fell.
That may not be the case the next time domestic stocks fall. If local problems hamper the U.S., then international competitors may benefit. Already, for instance, China's Baidu (Nasdaq: BIDU ) is seen as having stronger future growth prospects than its much larger competitor, Google (Nasdaq: GOOG ) , in part because Baidu has the homefield advantage in the world's most promising emerging market.
Both suffered huge losses during 2008's bear market, but Baidu has bounced back more strongly. And with Google considering abandoning China entirely, you might own Baidu as a hedge against U.S. economic troubles in the coming years.
Get bonded -- carefully
If stocks are risky now, bonds are even more so, for the opposite reason: A continuing strong recovery could send rates soaring, bringing bond prices down. Investors are flocking to bonds, which should raise your contrarian ire.
With higher rates almost inevitable, even the short-term bond exchange-traded fund iShares Barclays 1-3 Year Treasury (NYSE: SHY ) is vulnerable to price drops if short-term rates rise rapidly from their current 1% level. Even Treasury inflation-protected securities (TIPS) are vulnerable to rising real rates caused not by inflation, but by higher government borrowing and bond supply, making the iShares Barclays TIPS ETF (NYSE: TIP ) a riskier investment than it has been in the past.
So be careful in choosing fixed-income investments. If possible, choose ones you can hold to maturity to avoid capital losses.
Risk may be hiding, but it's still there. If you forget about it, it'll burn you. But proper planning can protect you.
There's a big risk to your retirement. Fool contributor Rich Smith writes about the day Social Security died.