Toddlers learn to steer clear of a hot stove after they get burned once, maybe twice. Investors, however, can be a little slower on the uptake.
This time last year, banks that were long thought to be "too big to fail" collapsed, investments that were considered safe imploded and retirement accounts got chopped in half. With such harsh lessons learned, some investors remain justifiably chastened. But now with the Dow inching back towards 10,000, it appears others have all-too-soon forgotten the events of last year.
Here are some of the lessons investors should have learned from the crash:
Lesson: Buy and hold doesn't always work.
The typical buy and hold advice goes something like this: Stay the course, ride out the market's swings and your portfolio will eventually bounce back.
Just try doling out that conventional wisdom to someone who was hoping to retire next year, or for that matter, five to 10 years from now. "If you're a long-term investor, your portfolio is now worth what it was worth in 1997," says David Hefty, a certified financial planner and chief executive of Cornerstone Wealth Management in Auburn, Ind.
That doesn't mean investors need to start day trading. Buy and hold still works in healthier markets, but in an environment like the one we're in now -- and may continue to be in for the foreseeable future -- investors need to be a lot more proactive than they've been in the past. "You have to abandon buy, hold and hope," says Hefty. "You have to be more nimble."
Hang onto a long-term investment strategy, but review that plan every six months to get rid of problem assets or make short-term changes, says Michael Kozak, director of wealth management at Cabot Money Management in Salem, Mass.
Lesson: Wall Street is not looking out for your best interest.
Wall Street's bankers and traders are in the business to make money -- often at your expense. "There is no such thing as unbiased advice coming from Wall Street." says Hefty.
The subprime meltdown is a prime example. During the housing bubble, Wall Street made monumental gains by repackaging subprime debt into complicated assets such as collateralized debt obligations. Bolstered by the housing bubble, demand for CDOs soared, surpassing the $1-trillion mark. Too bad many of the bankers touting these investments had no real clue about the true value of what they were buying and selling or the ramifications should the housing market go south (ahem, Merrill). When the bad debt was finally outed and the defaults started pouring in, the collateral damage (pardon the pun) was immense. Banks realized huge write-downs and the credit markets fell into a downward spiral.
If Wall Street is touting the next "big thing," proceed with extreme caution. Seek help from an adviser that has a fiduciary duty to look out for your best interest, says Kozak.
Lesson: Know how much risk you can stomach.
There's little doubt that investors felt helpless as they watched Lehman collapse and the markets fall into a downward spiral, but perhaps nothing was more dispiriting than when money market fund, the Reserve Fund, "broke the buck." In the 37 years since money markets had been around, only one other money market fund had seen its net asset value fall below $1.
Every investment carries some level of risk. The key is determining just how much of it you can stomach, says Carlos Lowenberg, president of Lowenberg Wealth Management Group in Austin, Tex. "Investors cannot view/use the stock market as a savings account," he says.
To help investors determine their risk tolerance, Lowenberg suggests dividing investments into three buckets:
Personal money you cannot afford to lose.
Market money you don't want to touch for several years
Aspirational money that's invested in riskier plays that you can afford to lose. "Some people may not have anything in that bucket," says Lowenberg.
Lesson: Always have an emergency fund.
Enough people have lost their jobs (7.4 million since the recession began in December 2007, according to the Bureau of Labor Statistics) to know that setting aside some cash for emergency situations isn't a luxury.
Typically, financial planners will tell clients that they need between three and six months of living expenses set aside in case of job loss, illness or some other financially devastating situation. But Lowenberg suggests that those with jobs that are at a higher risk of being cut, say in retail or financial services, should carry even more cushion than that.
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