How to Beat Risk Before It Beats You

In putting together a lifetime financial plan for your investments, you want to balance the risks you take against the returns you earn. But as the last year and a half has shown us, figuring out the right way to accomplish that task is easier said than done.

What is risk?
Most investors assess risk based on the characteristics of the asset classes they hold. Cash investments like money market mutual funds are seen as essentially risk-free; such vehicles are designed with the primary goal of preserving principal, even when doing so requires accepting extremely low returns. Bonds tend to have somewhat higher returns and are thus more volatile and can put principal at risk. Stocks, on the other hand, require investors to accept a much greater chance of substantial losses, but they pay the biggest rewards over time. By choosing a mix of investments, you can control your risk accordingly.

Most of the time, this model of risk management works pretty well, and the various asset classes behave the way people expect them to. But it's far from perfect. Recently, we've seen a number of cases where normal relationships have gone awry.

Are stocks the place to be?
The stock market's plunge has left returns on major stock indexes negative over the past decade or more. Meanwhile, interest rates on Treasury bonds reached extremely low levels last December before bouncing back in recent months. According to some recent research, those low interest rates raised bond prices so high earlier this year that their return over the past 40 years exceeded returns on stocks. That's raised a big controversy over whether stock returns give investors any risk premium at all.

Moreover, nearly all of the assets that typical households own have performed extremely badly in the past couple of years. Home values have dropped sharply in many areas of the country, as have shares of real estate investment trusts. Stocks of all types have performed badly. Commodities investors saw prices plummet late last year, although they've rebounded somewhat since then. Even many bondholders didn't cash in, as corporate bonds performed horribly in 2008.

And within stocks, typical assumptions have failed as well. Many investors rely on large-cap stocks, especially those that pay dividends, to have less volatile price movements than small-cap or international stocks. But plenty of stocks that people would have seen as rock-solid just a couple of years ago suffered huge losses, well beyond the market's losses:

Source: Yahoo! Finance. Current dividend rate is based on most recent dividend paid.

How to handle risk
These examples illustrate why you can't simply rely on old rules of thumb to determine how risky your portfolio is. While we've always been aware that results over short periods of time could differ greatly from historical averages, only now has it started to sink in that traditional return relationships can disappear for years.

Rather than giving up on diversification, though, recent experience supports counting on it even more. If you can't count on even the best-known blue-chip stocks to hold up in a bear market, then that makes small caps and international stocks more attractive -- because as it turns out, they're not necessarily all that riskier than their large-cap counterparts. And anyone who shifted all their money into Treasury bonds earlier this year made exactly the wrong move, as Treasuries have seen huge losses as stocks and commodities bounced sharply off their lows.

You can't afford to rely on outdated methods of controlling investment risk in your portfolio. By understanding that risk takes many forms and can be unpredictable even over significant periods of time, you'll build a portfolio that can work in both good times and bad.

Find out more about dividend stocks here:

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• Don't buy these overpriced investments.