Has the Economic Collapse Changed the Rules of Investing?
Money Magazine published an article with the “7 new rules of financial security,” claiming that the recent economic collapse has changed the fundamentals that investors have relied upon for decades. The simultaneous meltdown of the stock, housing and credit markets resulted in a world in which investors must adjust their assumptions in order to succeed. Here is what the writers from Money Magazine have determined:
1. Risk isn’t about how much decline in value you can stomach, it’s about not missing important targets. When weighing the risks against the rewards of any particular investment, financial advisers generally ask about whether the investor is comfortable with losing 50% from one year to the next. Investors, realizing that risky investments are necessary in order to for money to grow, agree to volatile investments when the threat of decline seems unlikely, like when the stock market has had a few years of great performance.
The past few years has tried these investors who claimed to be able to deal with a short-term decline, and many have bowed out of the stock market entirely. Money’s “new rule” is just a different way of asking the same question, without taking emotions into account. If you want to hit your target, you need to take on the risk appropriate to reach your goal. Getting scared in a turbulent market is fine as long as it doesn’t make you question your tenacity.
2. Cash is for more than just typical emergency funds, you should have enough to cover “asset emergencies.” In the economy before last year, the typical recommendation was that you should use keep three to six months’ worth of expenses in an easily-accessible savings account, but not much more. Any extra cash should be invested to “let your money work harder for you.” According to Money Magazine, you should keep enough cash to cover asset emergencies. For example, if you are counting on a 529 education investment account to provide for your child’s education, if he or she attends college in a down market, you could find yourself with not as much money available for tuition as you had planned.
If you are effectively allocating your invested assets depending on your target date for withdrawal there is no danger in the above example. You might include stocks in your 529 when college is eighteen years away, but as freshman year approaches, the account should reflect more conservative investments. Don’t rely on the all-in-one “target date mutual funds” to automatically allocate your investment between stocks and other investments at percentages that make sense; it will take some effort by the investor to monitor.
3. In addition to using your time horizon to determine the percentage of stocks in your portfolio, consider your earnings potential. Your “human capital” should be considered part of your asset allocation strategy. If your ability to earn income is strong, you can afford to take risk with your assets. Money Magazine offers the example of a tenured professor who is in line for receiving a pension, who can invest aggressively in stocks with their retirement portfolio, and a commission-based mortgage broker, who may want to secure a safer retirement.
4. Borrow cautiously rather than using debt (leverage) to seek higher returns. A number of gurus strongly pushed the idea of leverage — using debt to finance investments. It was a shaky theory at that time, and now we’ve seen the results of over-leverage and over-speculation in the real estate market and in certain investments. This doesn’t seem like a new rule; it’s just a rule that not many people were following. Mortgages acquired with no money down provide a nice return when house prices increase well beyond inflation, but historically and on average, real estate performs only marginally better than inflation. In order to achieve that average, the years of skyrocketing prices need to balance with years of plummeting prices.
5. Your home won’t make you rich. Again, I thought this was an old rule that was simply ignored for a few years during the real estate boom. I can’t tell you how many people who previously had never invested in anything were excited to tell me, after buying their overpriced house, that they would be fine and home values never decline. Others told me that real estate earns more than 10% year after year on average. Neither of these statements are true. It’s possible that my acquaintances who justified their purchases to me with short-term historical data ended up earning money on their house, “supporting” these statements. Anything is possible. But long-term growth in the house in which you live isn’t as guaranteed as people seemed to think.
Even if the house you live in does skyrocket in value, you normally can’t take advantage of the increase without selling your house and moving to a location where you can find a house of significantly lower value.
6. You need more diversification than you think in order to lower your risk. My retirement portfolio is diversified. I have a large-cap stock fund, a mid-cap stock fund, a small-cap stock fund, an international stock fund, a commercial real estate (REIT) fund, and company stock. Actually, that’s not diversified at all. Money Magazine offers stocks from emerging markets, domestic bonds, foreign bonds, and even junk bonds as part as a fully diversified portfolio. I have no bonds because I followed the common advice that those who have a long enough time frame should invest exclusively in stocks and bonds up to 5% of the portfolio won’t reduce risk to make the loss of potential growth worthwhile.
7. Don’t focus on retiring early. Money Magazine points out that delaying retirement by just one year may increase your annual income in retirement by 9%. That’s a nice raise. Someone who retired early in 2007 with a sizable retirement fund in stocks, expecting to live another 25 or 30 years — a decent time horizon for remaining in stocks under the “old rules” — have likely found today that their nest egg won’t be providing the same amount of income in the near future. Could the economic collapse have been predicted when this hypothetical individual retired in 2007? Possibly, but the threat of a stock market decline might not have been enough to convince a retiree to change asset allocation.
Do you agree with Money Magazine? Have the rules of investing changed due to the global economic crisis?
Article comments
Money Magazine if funny. I get they need to sell copy, but these are old, old, old rules, not new ones. Perhaps it was the ‘new rules’ from the 1990s and 2000s that made a mess of things, but to tout these as new is very funny to me.
Flexo, I’m no financial planner, but I think it’s important to have some percentage of your money in bonds (or fixed income funds) regardless of your age, (more as you get older). The reason is that they serve as a buffer from which you can buy and sell. You need to “cash in” when you rebalance once in a while for when all the funds go down as happened last year into this year. Also, if you buy bond funds in your 401K at each paycheck, you can buy more stock funds if the price goes down right after your company invests for you. Accordingly, I would say it’s better to have 10% in bonds and put 10% of your stock funds in an riskier realm. My other strategy is to overdiversify so that you can buy and sell between funds going up or down without paying penalties. It takes a while to build up enough to be able to buy into 15 different funds, also depends on how many are available to you. I was fortunate enough to switch jobs 3 times so I have a a current 401K (T Rowe Price), an old 401K (Fidelity), and a rolled-over IRA (Vanguard).
Flexo –
One thing that consistently bothers me is the use of the term “Economic Collapse”. The last time I checked, we are nowhere NEAR collapse. I am able to still walk out, buy gas, food, and a new car or home pretty easily. Easily is a subjective term, of course. Someone with mediocre credit cannot buy the car or home easily at all. But they can still engage in all the other things an economy requires to be efficient in terms of saving money and paying for essentials.
Yet this term “collapse” is used with abandon by very mediocre (not that you are…but most economic journalists are) journalists with little understanding of its meaning. Weimar Germany was an “economic collapse”. The things we take for granted – walking out and buying food and clothes – was NOT possible in Weimar Germany.
Today’s relatively harsh (though in the standard 64 years since WWII, it’s pretty average) recession, has caused people to FEAR recession rather than embrace it. Recessions are NOT BROKEN ECONOMIES. No matter what the politicians (most of whom are monumentally stupid) say, the economy is actually quite good. Evidence of this is clear – both Bush and McCain said this during the election, and suddenly Obama is saying it (after cynically telling Bush and McCain they were wrong during the election). While politicians are monumentally stupid, blind squirrels do find nuts from time to time…and it seems that here, they did.
The key to understanding recessions is to recognize that we all go through phases in our lives which require pullback and retrenchment. The government tries to shield us from this, economically, through deficit spending and manipulation of markets. This, of course, is unsound economics and causes boom and bust cycles which may moderate for a time (1982-2007) but eventually the dam has to break (2008).
Since we operate from a sound financial policy in our daily lives (save 10% of gross, use 25-30% for home/apartment payments, invest whatever is left over after paying other bills), we recognize that any alterations in our patterns will require us to “make up” later for shortfalls we incur today. On a macroeconomic level, this is a recession. Thus, it is not a “COLLAPSE”, it’s an alteration of policies to make up for what we missed out on earlier.
The current deficit spending by our government to “fix” the “collapse” may have good short term benefits. The long term aspects, however, are foreboding. If this is a “collapse”, we should be wary of what could happen in 3-5 years. There are several scenarios, and none are as rosy as this administration is painting (4% growth every year for 10 years?).
It would behoove our readers to carve out a very smart, conservative financial plan that conserves asset and capital at every corner, and maximizes USEFUL government tax breaks wherever possible (a tax break on home equity loans is NOT useful if it’s used to go on vacation, this is Weimar Germany borrowing). Savings of up to 15% would not be too much, either. Now is not a time for excessive investing. That time will come…but it is not now, unless you have spare cash on hand. (I’m a fan of taking advantage of today’s low stock prices – but you have to have a long time horizon to appreciate the value. We are going to go back down again.)
But my point, in saying all this, is that we are still CAPABLE of doing these things. Which means the economy is actually quite healthy, and not in collapse. The collapse is in asset prices – some of which were merely paper gains. I have checked my returns on my 401(k), and despite the market hitting 12 year lows recently, I had reinvested all dividends and I was only at a 7 year low! That’s bad – but not as bad as I was being told I was doing….which goes to show you how out to lunch people are.
We are told each week that unemployment has “hit a new record” for request for benefits. In pure numbers, that’s true. But compared to 1979, or 1982, we’re nowhere near records on a percentage basis. And percentages are the important thing here. Journalists tend to focus on the numbers that allow them to generate “outrage” or “sensation”. These two emotions are much more interesting than “complacency”. Which, if we review historical percentages, we have every reason to be complacent. This is, so far, not a horrible recession. It hasn’t matched the worst of the 1970’s at all. They SAY it will, and it may. But even if it does, it’s not “the worst we’ve faced since the Great Depression” – another common political sound bite.
I hope that in future commentary, we can reduce the hyperbole and increase the knowledge. This is the only way to imbue confidence, hope, and trust. And transparency. It’s a shame our administration hasn’t realized this.
Rick: You’re very right about the importance of semantics. It is not a full economic collapse, and I shouldn’t call it that. In some sectors though, with credit completely freezing up for a while for businesses and between banks… that can be arguably considered a collapse, but that’s just a small piece of the economy.
The fundamental rules have not changed and will most likely never change. But the way risk-tolerance and one’s investment horizon used to be assessed, can no longer be applied in a wholesale fashion. People need to consider their specific liquidity requirements and manage their cash inflows and (short term as well as long term) obligations accordingly (1). Similarly, a person’s career aspiration and its subsequent effect on cash flows and asset base needs to be taken into account as well. If one plans on returning to school, start a business, etc, his portfolio needs to be adjusted to offset risks posed by those cash needs.
One thing I forgot to mention about investing, and should be a “Rule” – when I was 15, my father told me “Whole Life is the centerpiece of any financial plan. Make sure you get a Whole Life policy when you graduate from college.” I did, and it’s one of the cheapest and most valuable investments I ever made. I have used it to borrow funds from time to time, and now I’m 1/2 way paid into it, my equity is very high, and it has provided me a solid basis for the future. My 2 mistakes? I didn’t purchase Whole Life for my 2 boys when they were born. The cost would have been infinitesimal, and would have given them a MASSIVE jump on life when they graduate from college.
People laughed at me, in 1992, when I purchased this. The question was “why? you can earn more by getting term, and investing the difference.” Possibly true, though by this point in time the difference would be quite close in valuation. One carries high risk, the other almost none.
A friend who did this, and mocked me, is currently in dire straits. He never locked in his gains and some of his investments have underperformed dramatically in the last 2 market pullbacks.
Here’s a simple question which I see silly people give the wrong answer to all the time:
If you have a guaranteed gain of 10% in 2 weeks, or a high risk investment gain which could provide 50% or 95% (5% loss) in 2 weeks, which is the better investment?
Most people (until recently) would’ve said the 50% gain. Today, that is being rethought.
A follow up question – how do you divide your investment dollars, if you have $2,000, in these 2?
Many people still say 75% in the 50% investment. This is not wrong, but it’s also not wise. 1/2, at best, and probably 75% in the 10% guaranteed is better. Sure, there is opportunity lost, but it’s a guarantee…and opportunity lost is no real loss at all.
Finally, if you have 2 investments which move in directly opposite proportion – a 100% gain in one will yield a 50% loss in the other – how do you invest your $2,000?
A little math will show that you invest 50% in each, which will guarantee a maximized gain.
This final rule is one reason hedge funds do so well….
Rick, I agree with you about the Richest Man in Babylon. This is the grand-daddy of PF books.
There will be over-reaction, and the “rules” will be changed for some people. But fundamentally, the “rules” are the “rules”. Investing is a money game and the goal is to get the most money. Some people learned that they don’t know how to calculate risk very well. I promise you that many will flee to “safety” which will basically lock them in to a low return situation while giving others the opportunity to make the big returns.
Flexo,
Money Magazine is out to lunch…or HAS BEEN, I should say. The rules have not changed. I have followed all these rules, which were taught to me ages ago. The “leverage economy” was one I continually accepted as “an idea that works for now”. But I always recommended against it to friends. Those who ignored my advice are on a very slippery slope today (most are hoping for a taxpayer bailout of some kind…but they are not AIG).
I am angry at magazines like Money that suggest the rules have changed. The problem is the rules “changed” a long time ago, but really didn’t. Magazines like Money just SAID they did in order to keep up with the cowboys on Wall Street. So we believed them. They were irresponsible.
The John Stewart/James Cramer joke comes to mind because Stewart’s criticism of Cramer was accurate (Stewart is wrong on most things, but not this). Cramer’s approach to investing and money was and is very bad. He is a freewheeling guy, and when you have as much money as him, it’s easy to be that way. His advice is good for someone with $1mm stashed safely and another $1mm to play with. But for people who are relying on their meager savings and income to meet their goals, and have their 401(k) as a their safety net, Cramer is a very poor person to rely on for advice. Suze Orman, someone I detest for my own reasons, is much better with the everyday advice.
My savings and investment philosophy has always been very basic. I read a book called “The Richest Man in Babylon” when I was very young, and I have passed it on to my kids. It is a great book with basic ideas on how to get ahead in the world financially. It is not 100% correct in concept for sophisticated money managers, but the everyday person, it’s 90% correct in its approach.
Money magazine is late to the game by about 20 years, I’m afraid. They simply were on the bandwagon for a long time and I never understood why. At the end of the day, while people will blame Congress, Bush, Clinton, Madoff, AIG and a myriad of others for this mess, the real cause is US.
Pogo was right when he said “I have met the enemy and he is us.” We simply hate to admit we are responsible for our own problems. But we are when we invest irresponsibly and save poorly. When we listen to men who CAN leverage out to 3 times their assets, while we are less capable of doing so, we put ourselves at risk. Then we blame the people we listen to…
These people are responsible to give good advice. But they should also explain WHY they are capable of doing the things they do and WHY things change as your asset base grows.
Money is like Quantum Physics. At very small levels, weird things happen and happen quickly. Probability alters the likelyhood of certain events in a grand fashion. But as quarks form subatomic particles, and these become atoms, the rules change dramatically. Eventually atoms form large scale material and Newtonian Physics kicks in…
MORE of anything means the rules change. This is true in Physics AND in Finance. But nobody ever discusses why this is true.