The past 3 years have been rife with changes – economically, financially, and socially. We’ve seen a lot of cultural and financial icons go very quickly from hero to villain. Many pop stars and sports heroes of the past decade have spent more time in tabloids than pursuing their chosen careers. Even President Barack Obama, once heralded as an instrument of change himself, has recently suffered a fall from grace.
Clearly we are in a period of historical transition and this is reflected in almost every sector of our society, including the financial realm. When the the economic recession of 2008 hit with a vengeance, it was interesting to watch as powerful CEOs, politicians, and central bankers who were formerly considered financial heroes became villains almost overnight. Much of this resulted from the fact that many of the financial orthodoxies of the past 30 years fell by the wayside in 2008 as some financial norms simply stopped working.
Challenging the Financial Norms
The economic crisis forced us to challenge some of the financial habits that had become standards over the past few decades. Here are a few assumptions that were widely questioned in the wake of the crisis:
1. Diversification Always Works
In 2008, we found out that all asset classes can go down at once. Those who sought safety investing in bonds were a little better off, but there was a point during the crisis where bonds fell as well. Investing in gold, normally considered a safe bet, eventually fell with all of the other commodities. It has since staged a massive rally, but at the time, it wasn’t treated any better than stocks.
Some have argued that the relentless search for uncorrelated asset classes has actually led to a real erosion in the benefits of diversification. As soon as one investment manager discovers an asset class that seems to move differently than equities, so many more pile in so that the diversification effect is lost. It’s the old “when everyone’s special, no one’s special” phenomenon. We have seen asset classes become much more correlated over the past few years, and it’s very visible in the increasing “everybody in – everybody out” market trading patterns.
2. Debt Is Normal
We saw this idea play out at all levels of the economy. Governments, corporations, and consumers all took on increasing amounts of debt. Interest rates were so low that it almost seemed like free money. We bought bigger homes, cars and televisions. Financial institutions used leverage (debt) to try to achieve above average returns in order to compensate for the low interest rate environment. Governments have borrowed astronomical sums for government bailouts and entitlement programs.
The one really important thing we all seemed to forget was that, even at zero percent interest, the principal still has to be repaid. It may also have slipped our minds that interest rates can go up as well as down. If that happened, servicing all of that debt would immediately become a lot more expensive.
3. Real Estate Always Goes Up
Many borrowed the maximum amount against their homes, trusting that they would continue rise in value. When real estate prices declined precipitously, they were left with little, zero or negative equity and a huge debt burden. Again, paying close attention to value is always a good idea. Prices that look too good to be true usually don’t last – in either direction.
4. Buy and Hold Investing
This is the investing approach where you set a personal investment portfolio asset allocation for stocks, bonds and cash, and periodically rebalance to bring your allocation percentages back into line. Many accepted that this was the only way to achieve long term retirement savings goals and came to expect the 7% annual stock returns promised by many financial advisors, books and media. But when the second market crash in a decade hit and investors found that they had lost money over a 10 year period, many wondered whether they had been duped by a financial industry that makes its money by holding onto ours.
That is not to say that you should be trading your retirement investments often. Most inexperienced traders lose money. But you can rebalance a little more strategically by selling investments that become over-valued. You can monitor your investments a little more closely, but resist the urge to tinker too often.
What Does It Mean?
What does all of this change mean for you, for your personal financial situation, and for your investments? Here are a few ways to cope with a changing environment:
Just recognizing that we are in the midst of a significant transitional period can make things a little easier. If you’re ready for a curve ball, you’re less likely to strike out as it crosses the plate.
Keep yourself up to date with the basics of current economic and financial information. Stay in tune with new investment trends and products and carefully decide which are right for you (e.g. Jim Cramer’s Action Alerts Plus)
Control What You Can
Even though financial laws, regulations and norms are changing, many of the basic tenets of personal finance will never change. It will always be important to track your expenses using tools like Mint.com and You Need a Budget (YNAB), spend less than you earn, and set flexible long term financial goals for your future.
Pay Down Debt
Right now interest rates remain very low. No one knows how much longer that will be the case. If you pay down your principal now, a rise in interest rates will be a lot less stressful and you’ll save a lot of money in future interest expenses. Getting out of debt will also put you in a position to turn compound interest from villain to hero as it helps you build savings rather than prolonging debt.
Have you made any changes to the way you handle your finances since the onset of the financial crisis?
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