How to Move Back Into Stocks While Keeping Risk to a Minimum

For investors, fear of losing money in the stock market is finally giving way to the reality that they may actually be losing money in low-yielding investments. With energy prices spiking, food prices creeping up and higher inflation looming, the "safe" near-zero yields of U.S. Treasury bonds and money-market funds are no longer acceptable to investors trying to build their retirement accounts.

Market watchers say a shift out of those safe-haven investments and into more risky alternatives has begun -- and will likely continue through 2011. But they also point out that volatility isn't going away, so it's vital to move back into stocks carefully.

Since November, the Investment Company Institute (ICI) has been reporting steady outflows of capital from bond funds. This past December, domestic stock funds recorded small inflows for the first time since April 2010. The ICI also reported money-market mutual fund assets decreased by $12 billion during the first week of 2011, suggesting that a repositioning of assets is definitely underway.

Bullish Predictions

Ryan Detrick, senior technical strategist for Shaeffer's Investment Research, estimates more than $600 billion flowed into bond funds over the last year, and much of that could now be heading back into stock funds. "There has been so much money put into bonds and money markets that if that money now works its way into stocks, that could be very bullish for the long-term fundamentals [of the stock market]," he says.

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That bullish prediction is supported by many recent upgrades for U.S. GDP growth in 2011, from about 2.5% to as high as 4%. Those forecasts suggest the economy has improved since last summer, when there was talk of a double-dip recession. The improving economic outlook, plus the anticipated steady flow of money out of bond and money market funds and into equity funds, should be enough to support a long-term rally in stocks.

Quincy Krosby, chief market strategist for Prudential Annuities, agrees that investors will continue to shift money into equities. But he points out that the trend began in mid-2010, when emerging-market funds were considered safer than U.S. equities, and investors increased allocations to these funds. Although 2011 could be the year investors return to U.S. equity funds in a big way, Krosby says they're not plowing their money back into equities blindly. Instead, investors have found a number of ways to get back into stocks while hedging their risks.

Here are some recommendations for investors considering the move back into equities:

Keep cash in your portfolio. Even if the economy expands as expected, market volatility is likely to remain high. So, pullbacks on economic news or unforeseen events like last May's "flash crash" are always possible. Available cash allows you to buy when the market is low.

"We would have a position in cash in the event the market sells off," Krosby advises. "It gives the investor an opportunity to take advantage of those pullbacks."

Maintain a diversified portfolio. Make sure your portfolio has as many different asset classes as possible, as a hedge against overall market risk. Krosby specifically recommends having positions in cash, commodities and several positions in fixed income -- including emerging-market debt, municipal bonds and high-yield bonds.

"If you are wrong about a particular asset class, you will have other assets in that portfolio that will benefit from whatever scenario manifests," she says.

Take profits and reallocate to large-cap dividend stocks. Large-cap stocks have been out of favor for some time, but many strategists believe they'll rally during the first half of 2011. They see investors moving more money into large caps because of the safety of their well-known names, their exposure to international markets, the solid dividend income they provide and the prospect of potentially lucrative stock buybacks.

"Take profits from where you've done well and reallocate," says Krosby. "U.S. large-cap, mega-cap and multinationals are attractively valued right now, and they offer dividends, strong balance sheets and management that can successfully navigate the global landscape."

Consider using options as a hedge against downside risk. Recent numbers indicate that investors are also moving more money into riskier small-cap and mid-cap stocks. Detrick says investors can use options to provide downside protection against trades they make to diversify their portfolios.

"People are still worried about market volatility," he says. "They can buy put options to hedge their portfolios against their trading."

Put options offer insurance against excessive loss by allowing the holder to sell the underlying instrument for a specified price during a specific time period. Detrick says individual investors have become more sophisticated, and as a result, options use has increased over the last year. He expects they'll continue to grow as investors look for ways to hedge against market risk.