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After a big stock rally like yesterday's, you might think you have nothing to fear from the financial markets. But the next market downdraft will soon have you worried about whether your portfolio is too aggressively invested.
Planning for contingencies is smart. But thinking that a drop in the stock market is the only thing you have to worry about could lead you to make huge mistakes in your investing approach. There are plenty of other things to fear besides falling stocks, and you have to make sure you're protected against all of the things that could go wrong.
Risk No. 1: Inflation
Inflation seems like the last thing you need to worry about right now. With the economy still advancing at a snail's pace, prices at the consumer level have stayed stable, and few people believe that higher prices are in the cards anytime soon.
The big question, though, is how long that will last. Warren Buffett has started adjusting his portfolio in anticipation of inflation, figuring that even if deflationary pressures are strong now, the bigger threat in the long run is a return of inflation.
You have several options to protect against inflation. The direct approach is iShares Barclays TIPS Bond (NYSE: TIP ) , which invests in inflation-indexed bonds that will rise in value if inflation returns. Another popular choice is to buy precious metals, either through iShares Comex Gold (NYSE: IAU ) and similar exchange-traded funds or by buying mining stocks.
But a third option is one many don't consider: buying stocks of companies with strong pricing power. PepsiCo (NYSE: PEP ) and Kimberly-Clark (NYSE: KMB ) have customer brand loyalty on their side, giving them the ability to raise prices to keep up with higher supply costs even in an inflationary environment.
Risk No. 2: Higher interest rates
Bonds have put in amazing performance in recent years, especially in contrast to a stagnant stock market. But rising interest rates could change that, and although the Federal Reserve seems in no hurry to raise rates, you can expect that to change in a hurry once a global recovery truly takes hold. Moreover, huge government borrowing puts upward pressure on rates even if the Fed does try to keep a lid on them.
Higher rates can cause losses for bond investors, with long-maturity bonds getting hurt the worst. So even though short-term rates are lower than long-term rates right now, moving your fixed-income portfolio to a shorter duration can help limit your losses when rates rise.
Risk No. 3: The decline of U.S. leadership
The U.S. has been at the center of the economic world for decades. It has the largest economy, the dollar is seen as a worldwide reserve currency, and it represents the ultimate consumer market for many global companies.
Recently, that U.S.-centrism seems to be changing. Emerging-market economies continue to grow, despite a global slowdown. While the U.S. faces record budget deficits and huge debt, China is seeking to fuel its growth by grabbing natural resources from around the world, as its sovereign wealth fund's investments in Canada's Teck Resources (NYSE: TCK ) and Brazil's Vale (NYSE: VALE ) make clear.
It's never been more important to have exposure to foreign investments in your portfolio. Whether you use the Vanguard Total World Stock (NYSE: VT ) ETF, which owns hundreds of different stocks, or invest in individual companies abroad, foreign stocks let you benefit from favorable economic activity elsewhere in the world. Foreign bonds and currency investments can protect you from a falling U.S. dollar while offering better interest rates in some cases.
Risk No. 4: Outliving your money
Keeping money in safe investments may prevent you from losing principal, but they won't help with a far more important problem: stretching your nest egg throughout your retirement.
Planning for a long retirement is a necessity now. Not only are people living longer, but many workers are being laid off toward the end of their careers, forcing them to tap financial resources earlier than they had expected.
Despite the risk of principal loss, investing in stocks keeps open the chance to get the growth you need to make your savings last as long as possible. In combination with a pension or an immediate annuity, dividend stocks can help supplement your income while also giving your assets a chance to grow.
It's impossible to eliminate risk from your investments. But by identifying all the risks you face, you can balance them and take steps to control each one as much as you can.
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