Risk vs. Return — the Unknown and the Treatable

Stock Market RiskOne thing you can’t do in the stock market is control the amount of returns you can generate. Dividends from solid companies provide a level of security, but look at what happened to BP. Anything can happen to any big company at any time. If you are invested in stocks, you are taking a big risk.

Risk isn’t only the other side of the equation; it’s also a factor that you can help control by choosing your investments carefully. I know a lot of people with a lot of money and I can tell that, once they accumulate a lot of wealth, risk-avoidance becomes a top priority. The problem is that it’s difficult to beat the rate of inflation without taking on some risk with your investments. And when you have a lot of money, you have a lot of salespeople calling you trying to sell you things.

Probably, the single best wealth-creating opportunity for individual investors in the past has been real estate. The recent housing crisis aside, you likely won’t find a wealthy investor whose portfolio doesn’t include some real estate.

Investing in real estate is a numbers game. You need population growth, an attractive location, and attractive financing. The cost of building and renovating will continue to go up, and building codes will increase. There’s little you can do to control your risk in real
estate, except not being overleveraged and owning the right asset in the right location. Time, of course, is always your greatest asset in this sector. And we may soon be getting to that time when real estate is a good value again.

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Getting back to stocks, if you look at the long-term charts of the main index averages, it’s quite apparent that the actual periods of significant capital appreciation in stock prices are short and few. Most of the time, the market is trading in mediocrity. This makes it very difficult to be a consistent winner at speculating in stocks.

We’ve been talking more and more in this column about having some portfolio insurance for your equity holdings. Some exposure to gold is a good start. This should already exist. The way the market is trading lately, I think a short position would be a wise option to
consider. I like the fact that the technology and railroad industries are saying that business is getting better. The problem is that investor sentiment is not.

If the Dow Jones Industrial Average breaks 10,000 in a meaningful way, then I think we’re in for real trouble. Right now, decent earnings are holding the index above this level. I get a sense in the marketplace that investors are anticipating an all-or-nothing type of outcome for the rest of year. Either the market’s going to tank or it’ll recover to Dow 12,000. Michael Lombardi has been writing a lot about the bear market rally still having life left. Combine that with my thoughts and maybe the market can do both: rally close to 12,000 and then come crashing down again.