Very few economists and financial experts believed a financial disaster like the one we are currently experiencing could actually happen. Over the spring and summer of 2008, oil prices rose to levels never seen before in the United States—which equated to a half billion dollar tax on American consumer’s spendable income. This was followed by the collapse of the mortgage markets, brought on by an aggressive price bubble with too many people buying homes they couldn’t afford in the hopes of being able to flip homes for a profit. Collapsing home values, and increases in mortgage loan defaults, created a meltdown in stock markets around the world.
Of course, the Federal Reserve Bank and the US Treasury propped up your financial systems with a number of different actions. As the markets fell to lows not seen in ten years, trillions of dollars in capital value have disappeared around the world and most of us have seen our retirement accounts drop by 20—40 percent. The resulting unemployment has turned a recession into the real possibility of a depression. Congress acted quickly to provide billons of dollars to financial firms on Wall Street, but failed to act on a bail-out for the auto industry. Its effect on main street businesses means we face the potential of having millions more unemployed workers.
This will at least extend the recession into the spring of 2009. A new administration and congress are getting ready to jump start job creation, and the housing and financial markets. The bright side of all of this gloom is with the stock market as low as it is and new action by our government poised to occur, we can see early signs that the recession will start to end by mid-year of 2009. While people may be losing a feeling of abundance in the financial sector, we still have a bright future ahead.
It is the feeling of abundance we must recover to get consumers to start spending again. And when they do, I hope it will be with a new perspective about what is important. I have to believe that America has heard the ching-ching of the cash register at the gas pump—high gas prices will return and we’ll have to invest in alternative energy, hybrid cars, and other ways to access passive energy sources in our homes, like solar panels and wind power.
It is also time to reassess how we think about our investments; how we invest our money; and how we measure the risks we are taking when we invest.
The very rich—the ones with access to hedge funds have been focused on three things—all of them wrong from a risk perspective:
1. Concentrated stock positions
2. Derivatives created from sub-prime mortgages with consumers who suddenly can’t repay
3. Unregulated hedge funds that lock up your money to take huge bets on the direction of the economy.
Many of the wealthiest investors are going back to the drawing board. The rest of us should be doing the same thing.
Here are six areas where your investment portfolio was likely to have been hit the hardest and where you can make adjustments to help handle any future shocks.
First, let’s redefine what a safe investment is. Until the fall of 2008, safe investments included investments backed by the United States government like Treasury bonds and other investments that could be quickly converted to cash, Money market funds, corporate bonds and auction-rate securities. Treasury bonds are still safe, though the yield on the three-month Treasury bond is almost zero, and at some point if other countries stop buying Treasuries, it might have to be re-evaluated. The other three are no longer safe havens. The market for auction-rate securities seized up? (were seized or frozen?) over the summer, and people who hold them have spent months fighting to get their money back. Auction-rate securities, have long been sold and marketed as being as good as cash—they are not.
Investment-grade corporate bonds are still trading but at very low yields, hit by the investment bank bankruptcies and the near collapse of AIG—the giant insurer. Money market funds are generally safe, but even they can lose value. In 2008, one of the largest money market funds “broke the buck”—that is the value of a share dropped below a dollar. Investors now have to be careful where they place their short-term investment dollars. The definition of a safe investment has become very narrow—US Treasury bonds.
Next, diversify across assets, and asset classes, is necessary to spread risk. For decades, the right investment advice was take your age and make the percentage of your total that goes to bonds, income funds, and cash (I don’t understand this. I’m 53. What percent should go to bonds, income funds, and cash in this case? 53 percent of each? Doesn’t make sense; don’t get it. Please clarify). This easy rule has been too simplistic for high net worth investors. Rather than manage their own investments, they pay high fees to hedge fund managers, who created concentrated stock positions to create highly leveraged positions and private equity, so-called alternative assets with higher returns for those willing to lock up their money for long periods of time. The problem is that many of these investments depend on borrowing, which means their values have plummeted as credit conditions tightened.
Investors now need to look to emerging markets, currencies, and commodities to create a more diverse set of asset classes in their investment or retirement portfolios. Remember two rules of thumb: First, keep the additional assets a small part of your total percentage, as risks change quickly. Second, keep your eye on the ball (what ball?). Investments in emerging markets, currencies, and commodities all can change in value quickly (overnight) so you have to be an active investor if you start diversifying in this manner.
Number three, buy and hold is dead. For many years, I taught investors to buy mutual funds and hold them for the long term. Invest in low cost index funds and you would see average returns of 8—10 percent. In 2009, that advice is dead. If you want to make money now, or even recover your losses, you have to be an active investor. Now is the time to buy a select set of stocks (at historically low prices) and rather than hold them, set target prices to sell them as the markets recover. The buy low and sell high (or at least a bit higher) is better advice for 2009. Markets will recover and stock prices will rise. Now is the time to position yourself for the recovery with a select portfolio of stocks. Again, if you also follow the principle of asset diversification, only invest 40—50 percent in individual stocks. It is still OK to keep money in mutual funds and bonds—just don’t expect those funds to recover quickly.
Next, evaluate the taxes. Over the past six to eight years, the value of most assets was increasing, so what you lost to taxes was not a big concern. This is no longer true and it will be necessary to evaluate the tax effect of an investment with a lower return. Rather than just depend on capital gains, it will be necessary to look at dividend income and tax free income. Dividend income becomes important when stocks are not growing in value. Most dividends are taxable, so if you reinvest dividends to grow the value of the stock holding, remember the income is taxable. City and State municipal bonds are one lower-tax alternative. Look for bonds from municipalities that have the ability to repay from tax revenues. California for example is hard hit right now. Yields will be higher, but it is necessary to look at the bond ratings carefully.
Number five, get real on housing. The era of your home being a constantly appreciating asset is over. Real estate investors have to look at long-term returns, true cash flow from investments, and re-evaluate how to make a hosing investment pay off. In the last year, the average house in America has dropped 20 percent in value, according to the Case-Shiller Home Price Index. In many places, it is much more than 20 percent. The buy today and sell next month (flipping) approach is dead. Investors and homeowners are going to be staying put. We need to return the era of buying a house primarily to live in with the expectation that after eight to nine years (the typical length of a mortgage), we will see some gains, but not the 10 to 20 percent a year seen over the last several years. More significantly, homeowners have to make sure they have the proper homeowners insurance to cover what they have.
Last, cover your risks. With your investments, take a more active role, ask questions and learn to watch the economic news and the financial markets. Invest broadly, rather than in a single investment, like your company’s stock.
Beyond the basics of theft and fire insurance, a homeowner needs to consider natural disasters like hurricanes and floods. In the today’s economy, the most important insurance may be an umbrella policy to cover the people who work for you. If your babysitter falls into your pool, or the guy cleaning the gutters falls off a ladder, the potential loss of wealth could be far greater than anything the stock market takes away.
Assess your true risk tolerance. The one upside of market conditions like what we are experiencing is they help people understand the need to assess their true risk tolerance.
Develop a “risk budget” which is the idea term of assessing an ability to handle market variations and swings in the value of your investment portfolio. Like all corrections, though, there is a risk that people will go too far the other way.
For some investors, losing 40 percent of $10 million still gives them some wiggle room. However, that same decline on $100,000 can be sobering. It still requires us to re-evaluate our view of risk—if not change our lifestyles. That soul-searching, done amid the possibility of lower returns in the near future, could alter spending and saving patterns over the long term. It is important to restore a sense of abundance to how you view and handle your investments, while taking a more prudent approach to new investment opportunities.

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