Trading Today's Market: Risk Management

This is no time to set and forget your 401(k) or IRA. Active markets call for active management.

When it comes to your 401(k) or IRA accounts, you can't afford to just sit around and let the market lead you toward retirement. Yes, the stock market offers inflation-beating returns in the long run (when measured over the course of a century), but those returns are lumpy. Investors can go a long while without earning any return.

Over the last 10 years, the S&P 500 has lost an average of 3% a year. Over the last five years, average losses for investors in the broad market are about 4% a year. So sitting tight isn't working.

Neither does the Target Date fund approach. Target Date funds try to give 401(k) investors an effortless way to allocate assets as they approach retirement. Young workers start out mostly in stocks, and as they get older, money is shifted into fixed-income and cash investments. But look at the Putnam Retire Ready 2010 fund, meant for investors looking to retire next year--it's lost an annualized 6.7% over the last three years, including a 27% drop in 2008 and a .7% drop so far in 2009. You don't want to be losing money right as you leave the work force.

So buying and holding the market doesn't work, and neither do a lot of Target Date funds. Market timing is impossible, but there is middle ground. You should actively manage your 401(k), IRA and other retirement funds.

Marc Lowlicht, who advises high net worth clients at New York's Further Lane Asset Management, says one thing investors can do is actively hedge their positions. If a client is in mutual funds, for example, Lowlicht will hedge their position by putting some of their money in an inverse exchange traded fund, like the type offered by Profunds.

So if you own the Vanguard S&P 500 but are worried about what happens to your money when the market is down, hedge your bet by putting some cash in the Bear Profund, a fund that goes up when the S&P 500 goes down.

Investors shouldn't try to jump in and out of the stock market, says Lowlicht. It's time consuming, expensive and you're bound to make your moves at the wrong moment. But that doesn't mean that you have to own every industry all the time.

"Investors need to be aware, and this happens time and time again, that the minute there is talk that you can't lose money investing in an asset, get out as fast as possible," he says. Lowlicht cites the familiar examples of technology in 2001, real estate in 2005 and oil in 2008. He now says that there's a building bubble in gold and recommends that investors cut exposure there.

Conversely, he says, "When there is talk that you can never make money in an asset class or that it will take years before that sector becomes profitable, it's probably time to start nibbling."

The problem with the passive approach is it robs you of an investor's most powerful tool: contrarianism--the willingness to buy what's out of favor and sell what's popular. Just leaving money in the market is akin to following the crowd, and, as we've learned lately, crowds can be very, very wrong for very, very long.