Why Your Portfolio Needs More Risk

How taking on some risk can make your portfolio safer.

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By any standard, money manager Malcolm Gissen has had a complicated relationship with risk over the past couple of years. After losing 62 percent in 2008, the Encompass Fund, which Gissen co-manages, gained a staggering 137 percent last year, cementing its reputation as one of the more volatile funds in the industry. "Most mutual fund managers tend to invest for mediocre results. Their goal is to perform in line with their benchmark," says Gissen, whose returns—for better or worse—have been anything but mediocre.

[See 7 Mutual Funds for Gamblers.]

Encompass is one of a small group of funds that have a "go-anywhere" mandate (meaning they can invest in essentially any type of security), and Gissen wields that power freely. Late last year, for instance, his fund had about 20 percent of its assets in gold-related investments. Despite all that, Gissen's attitude toward risk is surprisingly straightforward: "We don't like risk," he volunteers.

[See U.S. News's list of the 100 Best Mutual Funds for the Long Term, and use our Mutual Fund Score to find the best investments for you.]

This, of course, begs the question: What exactly constitutes a risky portfolio? "When people think about risk … they think, 'What's going to be the next AIG or the next Enron?'" says Chris Konstantinos, a portfolio risk manager at Riverfront Investment Group, a Virginia-based advisory firm. "That's a really important risk, but it's not the entire side of the risk equation. It's just one piece."

Lately, the market has shone a light on an entirely different type of risk, one that's far more paradoxical and difficult to grasp. "Sometimes the biggest risk you can have in your portfolio is not having enough risk," says Konstantinos. "And certainly since March of '09, that's clearly been the case."

Advocates of this philosophy point to two main scenarios. In one, a traditionally safe asset class falls off, pulling the rug out from underneath investors who were overexposed to it. That's what many analysts expect will happen to bond investors once interest rates start creeping up. In the other, a risky type of investment takes off, leaving those who don't own it behind in a cloud of dust. That's what occurred when consumer discretionary stocks surged during last year's rebound.

In both scenarios, the advantage goes to investors with portfolios that are traditionally seen as risky. The challenge, of course, is achieving the right balance. Many investors can't stomach the swings associated with funds like Gissen's, but there's middle ground to be found. "The right way to look at risk is to look at it from a portfolio construction perspective, which means that in a highly diversified portfolio, there's room for what's perceived as risky kinds of investments," says Konstantinos.

Notably, if employed correctly, seemingly "risky" bets can actually reduce the overall riskiness of an investor's portfolio. That's because they can serve as a hedge, protecting a portfolio against unforeseen events. Until fairly recently, these hedging strategies were, for the most part, only available to sophisticated institutional investors. But now, any retail investor can take part in them. Here's how:

Shorting. Investors who short a security essentially make a bet that it will decline in value. In its most aggressive form, shorting can open investors to limitless losses, but in its tamer iterations, it can be a valuable hedge. Lately, there has been a surge in the number of mutual funds that look to balance out risk through shorting. There are currently 97 long-short funds in Morningstar's database, up from 61 at the end of 2006. While some of these funds can be rather speculative, others take a cautious approach by carving out small positions in which they bet against the same types of securities that they bet in favor of in other parts of their portfolios. This makes the losses less painful should those securities take a dive.

The tradeoff is that two opposing bets can cancel each other out to a certain extent, meaning that investors in long-short funds shouldn't expect to see eye-popping returns. Over the past year, the 97 funds that Morningstar classifies as long-short have average returns of 6.6 percent. By comparison, an investor in Schwab's plain-vanilla S&P 500 Index Fund would have gotten a 25.2 percent return during that same period.