7 Lessons From the Meltdown

Editor's note: This story has been updated.

If ever something could be considered a teachable event, it's the current financial tsunami. When it's finally over -- and let's hope the end comes sooner rather than later -- it will provide enough lessons to fill up a doctoral seminar. But you don't have to spend $50,000 for a year at some elite university to acquire those pearls of wisdom. We'll give you seven for the cost of this magazine. These lessons won't restore your wealth. But someday, and maybe even before the financial markets recover, the knowledge will prove valuable.

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

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The reported $50-billion swindle orchestrated by Bernard Madoff, the $8-billion fraud allegedly perpetrated by Texas billionaire R. Allen Stanford 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.

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 statement listing all positions. Many advisers extol private real estate deals or energy partnerships. Ask for property descriptions: locations, addresses, photos. If you're an investor in a bundle of mortgages or business loans, do you know who the borrowers are? Investors in something called Agape World thought they had a piece of a package of well-screened business loans that paid as much as 16% with nary a default. The loans and the interest payments proved to be fake, and the investors lost more than $370 million total.

2. New investment gadgets won't save you.

Consider "long-short" mutual funds. As we noted in the March issue (Hedges That Didn't Get Hosed), 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 over­promised and underdelivered.

There's a good chance that other gadgets, such as principal-protected notes (see Savings Guarantees You Can Trust, April), 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 that were built around derivatives-trading strategies have already blown up. if you’re unwilling to take as many risks with the money you’ve made back in stocks, pair a fund that tracks Standard & Poor's 500-stock index with short-term government or municipal bonds.

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

Few people who get paid to predict the market's fluctuations get it right. 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). Those gains are no more sustainable than any irrational real estate or commodities boom. They aren't sources of market wisdom, but actors you cast to play a specific part during a disaster.

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.

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4. Wild swings over short periods are the new normal.

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 opening, don't sell then (unless the company has announced that it is filing for bankruptcy or that some other catastrophe has befallen it). Before midday, the bargain hunters will poach, narrowing that 10% loss to a more palatable 4% or so. If you need to sell, that's the time to do it. But unless you’re dealing with a specific company or some other narrowly defined investment, any big movement is random and has a good chance to reverse itself in the next few days

5. Cash is never trash.

The implication of this rhyme is that you're missing out if you hold a lot in money-market funds and the like. True, you'll never get rich earning 1% a year. But that's no reason to insult a larger-than-usual cash reserve. The beauty of cash in times like these 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 quality stocks fell more than 50% but have now risen substantially in the last six months. You couldn't buy them unless you had some money in reserve.

6. You're taking more chances than ever before.

The graphic to the left is called the "Pyramid of Risk." At its base are no-risk investments, such as bank accounts and Treasury bills. The higher up the pyramid you go, the riskier the investments get. By the time you reach its peak, you find such things as emerging-markets stocks, 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: Create your own pyramid by listing every investment you own (include your IRA, 401(k) and taxable accounts) and rating them from 1 for certificates of deposit to 5 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 accounts, money funds and T-bills up one notch and recalculate the result. You may find that your low-risk portfolio is actually medium-risk, or that your medium-risk portfolio is actually high-risk.

7. We live in a tightly wrapped world.

Not only do companies operate in more places in the world today, but also the economic fortunes of countries, regions and financial markets are increasingly interlocked. Did you know that 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. to avoid a virtual shutdown. A chart of the Taiwan stock exchange over the past two years marches in near lock step with 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 emerging-markets 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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