STOCK WATCH


8 Lessons From the Meltdown

Jeffrey R. Kosnett

The financial crisis can make you a better investor -- really.



Investment counselor Larry Swedroe joked recently that the financial crisis offers enough lessons to fill up a doctoral seminar. With apologies to Larry and begging the indulgence of readers, whom I don't wish to scold for errors and misjudgments (heaven knows, I've made loads myself -- and not just the past year), here's my twist on Swedroe's syllabus. These teachings won't replenish your family treasury. But someday, and maybe even before the financial markets recover, the knowledge will prove valuable.

1. Where's the money? You better know-- literally.

The Bernie Madoff affair and other fleece jobs should put to rest the notion that you can get rich from unpublicized investment opportunities unavailable to mere mortals. These secret deals frequently turn out to be Ponzi schemes or other scams. (Try our Is This a Scam? quiz.)

If you give any adviser discretion to buy and sell investments without your prior go-ahead, you must demand to know where your money sleeps. As a client you should get a monthly, if not online and real-time, statement of all positions and balances. If the statement contains a name you don't recognize, ask for details. Many advisers extol private real estate deals or oil and gas partnerships. Describe the properties, please: Locations, addresses, photographs.

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If you're an investor in a package of mortgages or business loans, do you know whom the borrowers are? Investors in something called Agape World thought they had a piece of well-screened business loans that paid as much as 16% with nary a default. The loans and the interest payments proved to be fakes, and the investors lost more than $370 million.

2. You're taking more chances now than before -- even if you don't know it.

There's a neat graphic called the "Pyramid of Risk." At the base of the pyramid are such no-risk investments as bank savings and Treasury bills. The next level has high-grade corporate and municipal bonds and blue-chip stocks. As you climb, you'll see small-company stocks and junk bonds and real estate. In the attic, you have such things as leveraged closed-end funds, emerging-markets bonds, commodities, and options and futures.

One of the unfortunate side effects of the financial crisis is that practically every investment has become riskier than it used to be. For example, money-market mutual funds are not quite the ironclad investment they've always been touted to be. High-quality corporate and municipal bonds have shown they can fall by double-digit percentages. Blue-chip stocks are capable of losing half their value in a year.

Here's an exercise for you: Create your own pyramid by listing every investment you own (include your your IRA, 401(k) and taxable accounts) and rating them from one for certificates of deposit to five for the most unpredictable holdings. Then total up your balances at each level and calculate a weighted average for the whole (in other words, the $100,000 you have in CDs counts for ten times the $10,000 you have in emerging-markets stocks).

Then -- and here's a lesson from the meltdown -- push everything except bank deposits and T-bills up one notch and recalculate the result. You may find that that low-risk portfolio you think you have is actually medium-risk, and that medium-risk portfolio is actually high-risk. Act accordingly.

3. The era of superstar fund managers is fading.

As a writer and editor for Kiplinger's, I'm guilty of lionizing managers such as CGM's Ken Heebner, Legg Mason's Bill Miller, Bob Olstein of the Olstein funds and Ron Muhlenkamp of the Muhlenkamp fund for delivering dazzling returns in good times. All of them are smart, hard-working professionals. But in almost every instance, money managers who stay around long enough eventually see their performance regress toward the average.

And, after years of sublime results, the path toward average can be deadly. Miller, after beating the market for 15 straight years, cost his shareholders dearly last year by sticking with financial stocks too long. As good as Heenber has been at divining the market's hot sectors, he couldn't help his CGM Focus fund avoid a loss of nearly 50% last year.

The more actively managed funds implode, the stronger the argument for indexing, particularly if we're in the middle of a long period of sideways or down performance from stocks. At the very least, you know that you'll pay minimal expenses with an index fund, and that's one of the few things in investing you can control. If you want to make bets on some geniuses, invest the bulk of your assets in index funds and exchange-traded funds and put actively managed funds at the periphery of your portfolio.

4. Don't deify those who warned about losses.

Few people who get paid to predict the market get it right, including me. But that doesn't make heroes out of those who are beating their breasts about how they prophesied the disaster. Spouting generalities such as "irrational exuberance" falls short of predicting crushing losses. It's especially important to keep this in mind as you examine the scintillating '08 results of such bearishly inclined funds as Federated Prudent Bear (symbol BEARX) and Comstock Capital Value (DRCVX).

However, if you have an adviser who isn't habitually negative but urged you to switch more into cash and Treasuries a year ago, then you should shower him or her with praise. Sending over a nice bottle of wine or a bouquet of flowers would be an appropriate thank-you gesture.

5. Cash is never trash.

The implication is that you're missing out by building a base of CDs and money-market funds. It's true you'll never get rich earning 1% a year, particularly if there's inflation. But that's hardly a reason to insult a larger-than-usual cash reserve. The beauty of cash in times like this isn't that it protects you from losses in stocks and other stuff, although it does do that. The lure of cash is that it enables you to pick up investments on sale. Gobs of high-quality stocks are down 50% or more over the past year. You can't invest in those stocks unless you have some money in reserve.

6. New investment gadgets aren't the solution.

Consider "long-short" mutual funds. My colleague Elizabeth Ody wrote in the February issue of Kiplinger's Personal Finance that these funds flopped last year in their mission of protecting shareholders in any kind of market. The idea seems sensible. By owning both long positions (that is, owning stocks the old-fashioned way) and short positions (which profit when the stock price falls), you play both ends against the other. But in practice, a fund that holds more longs than shorts -- which is generally the case in this category -- still loses badly in a harsh bear market. The funds' creators over-promised and under-delivered.

There's a high chance that other gadgets, such as principal-protection notes and absolute-return funds, will also disappoint because any complex trading "model" is vulnerable to unusual events, such as the failure of big banks or a two-year recession. A bunch of all-purpose bond funds built around derivatives-trading strategies have already blown up. If you believe stocks will recover but want to protect against further decimation of your portfolio, pair an index fund that tracks Standard & Poor's 500 with short-term government or municipal bonds. That's an effective defense -- and one you can understand.

7. Wild swings from hour to hour and day to day are the new normal.

The general trend in stocks, commodities and real estate has been down, but not straight down. How many times in the past year and a half have the market and sector averages fallen hard one day and soared the next? Or bounced more than 1% up and down several times during the same day's trading? "Fire, ready, aim" describes how traders act today. Don't expect any change soon, if ever.

For most of us, this pattern suggests that we should be trading less and holding longer, and putting little faith in those instant explanations of why the markets had a good week or a bad one. But if you do like to trade while the market is open, think about the time of day. If you own a stock that falls 10% at the market's open, don't sell then (unless the company has announced that it is filing for bankruptcy or some other catastrophe has befallen it). Before midday, the contrarians and bargain-hunters will poach, narrowing that 10% loss to a more palatable 4% or so. If you need to sell, that's the time do it.

8. We live in one tightly wrapped world.

Not only do companies operate in more places, but also countries, regions and financial markets are increasingly economically more and more interlocked. Did you know Brazil is a huge seller of metals to China and food to Russia and the Middle East? Such Asian "tigers" as Malaysia and Taiwan need growing orders from the U.S. or they'll virtually shut down. A chart of the Taiwan stock exchange over the past two years marches in near lockstep with one of the S&P 500. The correlation between U.S. real estate investment trusts and foreign REITs has become far closer in the past five years.

If you expect long-shot single-country funds or foreign stocks to override your frustration with losses in the U.S., you'll be disappointed. Instead of diversification by country, spread out across categories -- stocks, bonds, real estate, and commodities -- with both domestic and international selections. You'll be ideally placed when business recovers, which it will in Taiwan when it does in Tennessee.




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