4 hidden risks to your portfolio

A market like this one is difficult enough without accidentally adding risk to your portfolio. But a little knowledge and perspective can help you stay calm and avoid big blunders.

In recent days, queasy investors have run from stocks to bonds and cash, then back to stocks. But when investors react to daily market moves, they often go too far, experts say. Instead, smaller tweaks might be more beneficial.

Investing is inherently risky -- stock prices drop, companies default on their debt, even sitting in cash runs the risk of failing to keep up with inflation. And much of it, investors don't control -- including an unprecedented ratings downgrade for U.S. government debt, for example, or the precipitous, unforeseen market drops of the past two weeks.

Even so, there is plenty you can do as an investor to control risk, including making sure there's enough diversity in your investments to prevent everything from moving in lock step. You should also have a clear, long-term plan, which can offer perspective when the short term doesn't go your way. "If you focus on those big levers that you absolutely can control then you actually stand a great chance of being successful," says Chris Philips, senior investment analyst for Vanguard's investment strategy group.


Obviously, there's no way to eliminate all the risks in investing. Sometimes, surviving a market swoon feels like exactly that: survival. But there's no reason to make it worse than it has to be. Here are four common investing mistakes that add unnecessary risk to a portfolio -- and how to fix them:


Reality: Some bonds are safer than others.
Until last week, U.S. Treasurys were considered risk-free, with no chance at all that the issuer (aka Uncle Sam) would fail to pay up. Post-downgrade, investors may be able to see a bigger picture: Bonds of all kinds can carry hidden risks. They still have a place in a portfolio, advisers say, usually to generate income and to provide stability -- when stocks fall, bonds often rise, or at least don't fall as much as stocks. But within the universe of bonds, there's a wide range of risk, which make some issues far more vulnerable to big losses than others. The more a bond pays in yield, the riskier it is. High-yield corporate bonds, for example, commonly called junk bonds, can offer yields an average 6.6 percentage points above Treasurys. They also have a higher risk of default. Over the past 12 months, 2.2% of high-yield bonds defaulted, according to Standard & Poor's Global Fixed Income Research; during the same period, no investment-grade bonds did.


The fix: Don't chase yield.
Even with high-yield bonds, the odds are still in the investor's favor, but they're also some of the most volatile issues around, with prices that tend to rise and fall more like jittery stocks than mellow bonds. To reduce risk, investors should have no more than 7% of their bond portfolios in high-yield bonds, says Ron Florance, managing director of investment strategy at Wells Fargo Private Bank. Investors should diversify with other bonds, such as municipal bonds, investment-grade corporates and foreign issues, he adds. And while investors can't control rising interest rates, which also erode the value of bonds, Florance recommends sticking to bonds with short maturities -- about seven years or less -- because they will get hurt less if rates go up.


Reality: A dozen funds -- or even a mix of stocks and bonds -- may not cut it.
Households that invest in mutual funds own about seven funds apiece, on average, according to 2010 data from the Investment Company Institute, a mutual fund industry trade group. That ought to be enough to get good and diversified, no?

A closer look often reveals that even with a passel of funds, portfolios can be far more concentrated than they first appear. Investors often fail to realize that they can be holding two or more funds with very similar strategies, which isn't always apparent in a fund's name or track record, says Todd Rosenbluth, a mutual fund analyst for S&P Equity Research. An investor who owned the $61 billion Fidelity Contrafund (FCNTX) and the $24 billion T. Rowe Price Growth Stock (PRGFX) fund, for example, would end up essentially doubling down on information technology and consumer discretionary stocks, according to S&P.

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