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?