Is Your Portfolio Light On Stocks? It May Be Time For A Switch

By Jean Folger | January 05, 2011 AAA

Many investors have either significantly lightened up their stock positions or entirely eliminated these investments from their portfolios in response to the economic downturn of the late 2000s. Much like falling off the proverbial horse and finding the gumption to hop back on, investors, still gun-shy from demoralizing losses, are having to dig deep to find the courage to get back in the stock market. (For more, see Guard Your Portfolio With Defensive Stocks.)

While investors have turned to lower-risk investment instruments like U.S. Treasury bonds held to maturity or FDIC-insured certificates of deposit (CDs), the return on these low risk investments is, of course, low. Investors are rewarded for taking risks, and where there is little risk, there is little reward. Though some investors will remain comfortable with safer investments and smaller gains, others may be ready to climb back on the horse in search of greater gains.

IN PICTURES: What Is Your Risk Tolerance?

Opportunity Cost
While low risk investments like bonds and CDs do allow investors to sleep at night, they currently do not offer any opportunity for significant growth. For example, Bankrate.com lists overnight averages for CD rates: the national average for one year CDs ranges between 0.25% and 1.4% APY; for five year CDs, rates are currently between 0.5% and 2.61% APY. The S&P 500, on the other hand, enjoyed returns of about 13% during 2010.

That is not to say that all stocks have experienced similar gains in the past year; however, many stocks have steadily been gaining traction since 2008's fallout. While low risk investments make investors feel better (and safer) these days, the opportunity cost for tying up money in low return investment vehicles must be considered. Every dollar that is tied up in a low yield bond or CD has the potential to earn much higher returns in stocks, albeit the returns are not guaranteed. Each investor must consider the opportunity costs of keeping money in low yielding investments and decide for oneself if the increased risk of stocks is worth the potential for greater rewards.

IN PICTURES: Learn To Invest In 10 Steps

Confidence
After nervously holding on to cash, many companies have announced plans to use significant cash reserves - or even low-interest loans - to initiate large share buybacks. In addition, the companies sitting on a lot of cash may, as confidence grows, raise dividends, consider mergers and acquisitions and put money back into their businesses. As companies gain confidence and as more individuals return to the stock market, the ensuing confidence could be contagious, creating a more promising investment environment for everyone. (It may not always be good for shareholders, see 6 Bad Stock Buyback Scenarios to learn more.)

Volatility
Businesses and individuals alike, however, will necessarily remain cautious due to the market's volatility. And while the current volatility needs to be acknowledged, it need not be an excuse to avoid the market altogether. Short term investors and traders, for example, thrive on the market's price swings to earn a profit. Buy and hold strategies have long been proven profitable over time. However, current economic and market conditions, combined with investors' hesitation to trust that the stock market will provide reasonable gains (and not catastrophic losses), may result in more actively managed investments, including shorter-term stock positions. In other words, instead of buying 500 shares of XYZ stock with the intention of holding the position until retirement, more investors may opt to think in terms of one year or five year investment horizons. (To learn more, see Buy-And-Hold Investing Vs. Market Timing.)

Once Bitten, Twice Shy
Indeed, there have been a few periods where investing in the stock market was "as easy as printing money." Consider the dot-com bubble of the late 1990s. At that time, 30% yearly returns were common and many investments were doubling each year. While these huge gains were more of an accident and less of a sound investing strategy, investors in the late 1990s enjoyed the bull ride while it lasted. And while investors during the mid to late 2000s were not expecting these types of atypical returns, they were not prepared for the punishment the market was about to dole out as the economy faltered.

The Bottom Line
Unfortunately, there will be no flashing lights or alarms to indicate that it is "safe" to return to the stock market. Generally speaking, it will take increased market participation (i.e. more investors) to create a more stable and potentially profitable investment environment. And since investing is unlike a poker player's all-in bet where he must place his entire stake in the pot, investors can limit their stock market exposure as much as they want. Small positions, closely managed stop losses and profit targets and shorter-term time horizons can limit the risks investors must assume in the stock market. One thing is certain: low risk investments only offer low rewards. Investors may find it advantageous to at least consider putting money back into the stock market - even if it involves small positions that are carefully monitored and not necessarily in for the long haul. (For a whole lot more, check out our Investopedia Special Feature: Investing 101.)

For the latest financial news, check out Water Cooler Finance: Conflicting Job Reports And A Facebook IPO.

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