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Live and Learn

About
Stan Hinden

1. A Matter of Trust.

   The American financial system was built on trust. On a personal level, it enables us to deal with banks, investment firms and finance companies that offer mortgages and car loans. On a national level, trust is the key element in business-to-business financing and bank-to-bank transactions. In short, trust is the grease that allows the wheels of commerce to turn.

   But trust is also a fragile thing. And it has taken a real beating this year. Millions of investors lost both their savings and their trust in Wall Street when icons of American business-Fannie Mae, Freddie Mac, Bear Stearns, Lehman Brothers and AIG-became victims of their own rampant risk taking.

   Trillions of dollars of retirement savings were lost when stock prices plummeted this year after the collapse of the markets for sub-prime mortgages and exotic mortgage securities. When those markets ceased to function, it was largely because investors could not trust-or understand--what those securities were worth.

   The lesson from this financial tsunami is that trust can no longer be taken for granted. It must be verified. To survive, the investment industry, the banks, the regulators and the corporations will have to prove to investors once more that they can be trusted with their money. And that will take some time.

2. A Question of Value.

   When times are good, it is very easy to forget a basic investment principle: "At any given time in the market, a stock or bond is worth only what somebody else is willing to pay for it."

   It really doesn't matter that you paid $100 for a share of stock, even if all the investment yardsticks said it was worth $100. When a market decline takes the price of your stock down to $50--even if the company fundamentals have not changed-that stock is now worth only $50.

   That may seem unfair and even irrational. But investing in a company is not just about its earnings, sales, cash flow and book value. It is also about investors' perceptions of the value of all stocks at a given time. And when the financial and economic climates change, the stock that was once worth $100 is suddenly worth only $50 because that is all that anyone will pay for it.

   That is a truly painful experience for investors but what they must learn is: Value, like beauty, is in the eye of the beholder. And it is subject to change without notice.

3. No Place to Hide.

   The common wisdom is that the best way to survive market downturns is to put your savings in a variety of investments. The idea is that when one goes down, another will go up. But as we have seen, there are times when almost all investments go down together. In principle, diversification is still a good strategy, but it is not foolproof. If a rising tide raises all boats, an outgoing tide can lower them, too. And it can take a long time before we see the next high tide. Thus, the lesson is: If you think you are going to need your money-or part of your money-in the next five years, it is probably not a good idea to put the money at risk in the stock market.

4. Keeping Calm in a Storm.

   When the economy is strong and people feel confident about their jobs and their investments, they tend not to think about the need to establish a rainy-day fund, a fund that contains enough cash to pay for at least six months of living expenses. This is the kind of fund that people cherish when their jobs go away, housing prices fall and stocks lose much of their value. Setting up a rainy-day fund, when markets are doing well, may mean you'll have to give up some market gains to have quick and easy access to your money. But when financial storms arrive, you'll enjoy a sense of calm, knowing that you do not have all of your money at risk. The rainy-day fund also will teach you an important investment lesson: There are times when cash is king.

5. Finding Security in an Insecure World.

   If the events of 2008 have taught us anything, it is the value of steady, reliable retirement income. Social Security is the perfect example. It provides retirees with a regular flow of income that rises with the cost of living. Employer pensions are another example, although they do not usually come with cost-of-living adjustments. Annuities also can provide a source of steady income, although choosing the right annuity can require considerable study. One bit of advice for younger workers: If you are in the job market, and have a choice of employers, choose the one with the best pension plan.

   For future retirees: You'll sleep a lot better if you know that your regular monthly income will cover your living expenses no matter what the financial markets are doing.

6. Living Within Your Means.

   When our savings and investments take a big hit, we feel poorer and begin to cut back on our spending. Thus, the $3.87 latte that we enjoy every day suddenly becomes a luxury we can do without. With gasoline at about $3 a gallon, that 50-mile Sunday drive into the mountains to see the fall colors suddenly doesn't sound so appealing. And we also find we can cut back on our visits to our favorite restaurant--where we spend $50 to $60 for two persons.

   We also can economize by subscribing to fewer magazines, taking fewer garments to the cleaners, and reducing our supermarket spending by doing more careful meal planning.

   But, of course, that raises some interesting questions: "Why don't we practice frugality all the time? Why don't we try to live, not only within our means, but below our means?" The answer: Self-discipline is always hard but the opportunity is there. If we could learn to be truly thrifty, we might be a lot better prepared for the next market crash and extended recession.

7. The Market Will Come Back.

   Among people who work in the investment community, it is an article of faith that bear markets are always followed by bull markets. And, indeed, history is on their side. During the last 100 years, the stock market has gyrated in the short term but risen steadily in the long term.

   While that is a comforting thought, it doesn't tell us how long it will take for a deep bear market to resume its upward path. Indeed, if the U.S. recession and market decline become part of an extended global economic downturn, it could take years for the U.S. stock market to recover from its recent 40 percent drop over 12 months.

   The belief that the market will rally eventually also doesn't tell us what the casualty list will look like when the market does recover. When the Tech Bust took place in 2000, hundreds of companies disappeared from the stock charts and their shareholders lost everything.