Are you the next Lehman Brothers?
The errors that killed the big banks were so elementary anyone could make them. Be sure you don't.
(Money Magazine) -- On the surface, this financial crisis seems pretty complicated. Wall Street firms made convoluted bets on exotic mortgage securities, and those bets failed for a complex set of reasons. But in fact, investment banks went under for reasons that were quite basic.
Lehman Brothers and Bear Stearns collapsed because they forgot the very principles they urged on their individual clients - such as diversifying and understanding the risks associated with one's investments.
So let's take a look at the key mistakes these financial firms made, to see that you're not falling into the same traps.
One of the biggest mistakes the investment banks made was piling into what they thought was a safe investment: mortgage-backed securities. At the same time, they were taking on obscene amounts of leverage.
In other words, they borrowed to amplify their bets. Overall, Lehman and Bear Stearns leveraged around 30 to 1, meaning that for every $30 wager, they put up only $1 and borrowed the rest. With this degree of leverage, equity would be wiped out if investments lost just 4%.
As an individual investor, you'll never take on this degree of leverage. But you may be inadvertently betting the house on a single seemingly safe asset: your employer's stock.
Bear Stearns' downfall in March should serve as a vivid reminder of the risk in putting too much financial capital (401(k) dollars) in the same basket as your labor capital (your job).
At the time, employees owned a third of Bear's collapsing shares. The typical 401(k) investor is taking on too much of this type of risk. A Hewitt survey shows that more than a quarter of their retirement equity portfolios are in company stock - the same as in March (see the chart to the right).
Was it possible that home prices could fall substantially? Of course it was. Yet financial firms acted as if this could never take place. Similarly, fund investors seem to be shocked to learn that equities can lose more than a third of their value in a single year.
In the first half of October, they redeemed a record $56 billion out of their equity funds. But just because the S&P 500 hasn't lost more than 30% in any calendar year in seven decades, don't assume it can't happen.
This bear market should serve as a wake-up call: If you want to invest mostly in equities, make sure you have ample time to make up for steep losses.
On Sept. 11, Washington Mutual said it was confident that it had "sufficient liquidity to support its operations." Four days later, depositors began a run on the bank, pulling $16.7 billion out in just 10 days, which shut the thrift down.
Scary, right? Well, your own personal cash pile could evaporate just as quickly if, God forbid, you or your spouse got laid off.
The lesson: Make sure you have sufficient reserves to draw on in a crisis. An old rule of thumb says to keep six months of expenses in cash. With unemployment up to 6.1% - and likely to climb - the prudent strategy would be to build an even larger reserve, perhaps up to a year. Start now.