3 smart ways to lower market risk

The past month has reordered global risk and reward.

It's not just that the Standard & Poor's 500 Index ($INX) fell 17.8% from its July 21 intraday high to the Aug. 9 intraday low. Or that the German index, the DAX ($DE:DAX), is down nearly 25% in the past two months. Or that emerging markets such as Brazil and Shanghai spent time in actual bear market territory.

But we've also seen eurozone leaders unable to put an end to the euro debt crisis. We've seen the Standard & Poor's credit rating of the United States go from AAA to AA+. (Fitch Ratings reaffirmed the U.S. as AAA on Aug. 16.) Japan has slipped back into recession. Inflation has topped official targets and has been stubbornly resistant to central bank policies. Economic growth has slowed or threatened to slow in most of the world.

Trends that investors depended upon to value stocks -- or to tell them where and when to chase momentum -- are broken, damaged or threatened.

Stocks are cheap in most of the world's stock markets -- if past trends reassert themselves after a short interruption. If the trends are truly broken, however, who knows? What's a Google (GOOG, news) or a Vale (VALE, news) or a Baidu (BIDU, news) worth if domestic and global rates of economic growth are about to drop by a percentage point or two -- or more?

What's normal now?

You have the option of stubbornly insisting that things are headed back to normal. Or that growth and stock prices will revert to the mean. But that begs the question of what normal is and where the mean might be.

Unless you're willing to throw out the data on economic growth and performance of individual asset classes from the past decade (or more, I'd argue), it's hard to come up with a long-term trend that can be convincingly projected a decade into the future. And even then, your trend line would still have to come to terms with changes in global demographics and the global economy that, to me, indicate that the next decade will indeed be different.

To the degree I can, I prefer not to make investing a matter of faith or a gamble on alternatives with unknowable odds.

"To the degree I can" isn't a very large measure right now. For example, I think the most likely range of U.S. economic growth is somewhere between 1% and 2.5% for 2011 and 2012. Doesn't sound like much of a range? Just 1.5 percentage points? Certainly, but the swing is 150% from the minimum and 60% from the maximum. And, of course there's no guarantee that the actual outcome will fall within that "most likely" range. (We've got some recent experience with results that fall into the narrow tail of improbable outcomes, but that nevertheless turned out to be very real.)

Global economies are more unpredictable

And the United States is by no means the hardest economy to handicap right now. Brazil is inflating its own credit bubble, the government's will to restrain wage increases is questionable, and inflation is not under control. In the eurozone, the European Central Bank has seriously damaged its credibility, leaving the restoration of confidence to political leaders who won't lead and to a European Financial Stability Facility that isn't yet ready to go into operation. Indian politics make U.S. politics look like a model of rational discourse. And, while the Reserve Bank of India may be the last adult in the room, any parent will tell you that batting the children around doesn't usually produce good behavior.

I could go on. But I think you get the point.

3 themes for reduced risk

I don't think there's a magic method for bringing reasonable certainty to our projections about the global economy and about most national economies. We're stuck with the fact that these are uncertain times. The result of that, unfortunately, is that it's very hard to tell in most parts of the financial markets, and especially in the global equity markets, what the risk might be. You can calculate the reward but not the risk. That's the investing equivalent of dividing by zero.

Yet I do think there are three parts of the global equity markets where the risk/reward proposition more than just calculable, it's actually in the investor's favor at the moment:

No. 1: Dividend-paying stocks

If the global economy continues to slow, global interest rates will head down, and that will make dividend yields worth more. The value in a 3.5% -- or better -- dividend yield on a stock such as DuPont (DD, news) or Abbott Laboratories (ABT, news) when the 10-year Treasury is hovering near 2.1% should be clear to most investors.

The proposition becomes even more attractive when the dividend is paid in a strong currency such as those of Norway, Sweden, Switzerland, Australia or Canada. Take a look at the 5.1% yield from Norway's Statoil (STO, news) (STL.NO in Oslo). Australia's Westpac Banking (WBK, news) (WBC.AU in Sydney) pays even more, 7.5%. For more on this, see my recent column "How to pick stocks in an ugly market."

I can think of two kinds of downside risk with this strategy. First, the individual company may not be able to keep up the dividend stream. I think you can minimize this risk by buying shares with strong cash flows behind them. Second, the global economy might do better than expected, leading to higher interest rates and higher inflation, which would reduce the value of the dividends. That is why you're also looking to buy strong businesses. Shares of these stocks should go up if the economy grows more quickly than is now anticipated.