Today's market won't reward big risks

December 16, 2005

Investment Consult

We've heard the mantra "No risk, no reward" so often that many of us automatically assume the opposite-if we take risk, we'll get the reward.

I've noticed that within the past year or so, people are much readier to accept risk. Partly, that's because the anguish of watching your portfolio lose 30 percent, or more, of its value has faded into a memory. Beyond that, people are coming to grips with the idea that the US stock market isn't going to bring any great returns for the foreseeable future. Compare the incredible past performance of the S&P 500, up 37.5 percent in 1995 and 28.7 percent in 2003, as the market recovered. Many people had based their plans for retirement on earning in the range of 10 to 12 percent a year. Since experts now predict single-digit returns, at least for several years, investors think greater risk will get them the returns they need.

I usually do the opposite. When I see a category that has done pretty well, I shy away from it. Here are some things that I'd be cautious about.

Emerging-markets mutual funds. I've seen a lot of interest in these lately. News reports about developing markets have captured people's fancy with visions of lucrative returns.

And in recent years, they haven't disappointed: Emerging-market mutual funds have averaged 32.1 percent over the past 12 months (all returns in this article are as of Oct. 31, 2005); three-year returns are also 32.1 percent; but 10-year returns are an underwhelming 6.5 percent. For the same time frames, the S&P 500 brought in 8.7 percent, 12.8 percent, and 9.3 percent, respectively.

Emerging markets are very vulnerable to all kinds of ups and downs. Most developing countries don't have the infrastructure, healthcare system, or political stability that best support continuous growth. I'm not saying you should totally avoid emerging markets, but don't take large positions in them.

Junk bonds. Junk bonds represent another arena where I've seen people taking unnecessary risk, without strong upside potential. So-called junk bonds (more generously described as high-yield bonds) usually have higher yields than better-quality bonds, because they're lower-rated and are riskier. The companies offering junk bonds tend to grow slowly and have low valuations. To attract investors, these companies offer dividend yields at least twice the S&P 500 average. For assuming the extra risk, some of the yields have been as high as 14 percent.

But as the prime interest rate has risen, the once-wide yield spread between junk bonds and US government bonds has narrowed, to about four percentage points these days-not an eye-popping difference. Even in the best-case scenario, you won't get much more for assuming the additional risk.