The 7 new rules of financial security

In a world turned upside down, you must re-examine some basic assumptions. A good place to start: understanding the true nature of risk.

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By Carolyn Bigda and Paul J. Lim, Money Mag

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(Money Magazine) -- John Maynard Keynes, the Depression-era economist who's having quite the comeback, once quipped when he was accused of inconsistency: "When the facts change, I change my mind. What do you do, sir?"

Money has long advocated the benefits of consistency in your investing and financial planning. People who swing between bold risk taking and neurotic conservatism almost always get their timing wrong, falling for the hype in the good times and missing the real opportunities in the bad. But occasionally the facts change too much for you to stick to old ways of thinking. This is one of those times.

The past year has seen the simultaneous collapse of the stock, housing, and credit markets - and now of an economy that relied too much on all of the above. So how do you adjust? First, think hard about the risks you face, because they may not be what you thought they were. This can change how you save, invest, borrow, and plan. In this story, we'll examine the flaws in the conventional wisdom about managing your money and propose some new rules for the road ahead. In How to play by the new money rules, we'll show you how to apply them to each stage of your life.

Rule No. 1: Risk

OLD THINKING: If you can stomach the ups and downs that come with risk, you'll be rewarded.

NEW RULE: Risk isn't about your stomach. It's about making or missing an important goal.

Whether you're investing, buying a home, or making a business decision, you know you have to consider risk. But what is risk? It's a tougher question than it appears. Many of us have learned to think of risk as synonymous with volatility. You always understood that technology stocks and Miami condos could deliver sharp ups and downs. But for years - and in the case of equities, for more than two decades - what came down reliably bounced back even higher. You could easily conclude that risk tolerance was just a matter of taste, akin to preferring the extra-hot sauce on your barbecue. As long as you had the fortitude to see the occasional loss on your 401(k) statement and not panic, you would capture superior returns over time.

As you now know, the "over time" part of that last sentence is the real risk of relying too heavily on stocks. The longest period of negative returns for U.S. equities is 16 years, according to data collected by Wharton economist Jeremy Siegel. And we're at over a decade as of late February.

If you hit a slump in returns at the moment you need the cash, the eventual upside of volatility won't do you much good. Consider the analysis from T. Rowe Price, which shows the impact of a weak market in the first five years after you retire. Because you have to sell falling assets to live on in the early years, your portfolio may be so small by the time the rebound comes that you still run out of money. Unfortunately, many Americans were especially vulnerable to today's downturn. According to the Employee Benefit Research Institute, more than 30% of near retirees had 80% or more of their 401(k)s invested in stocks.

WHAT TO DO: You shouldn't run from risky investments just because they lost money - that train has left the station. But the old buy-on-the-dips advice isn't quite right either. This bear market's lesson is that how much risk you can take is a matter of how much you can lose and still meet your basic goals. That may mean scaling back on stocks, even if you miss some of the next market rebound.

Rule No. 2: Cash

OLD THINKING: Keep enough money in ultrasafe accounts to cover life's emergencies, but no more.

NEW RULE: Relying more on cash can rescue you in an "asset emergency."

For most of your career you'll want to set aside about six months' worth of living expenses in the bank. That money covers the mortgage and puts food on the table should you lose your job. The fact that you'll earn only about 2% is beside the point. You can't take the risk. But what do you do after you build that cushion? Until last year the usual strategy was to put your savings to work for higher growth.

But the simultaneous crash in stocks and houses has taught us that we need to redefine "emergency." It's not just something that happens to your income: There are asset emergencies too. If you had been counting on investment proceeds, a 401(k) loan, or home equity to pay a college tuition bill soon, you know exactly what that means.

Rande Spiegelman, vice president of financial planning for the Schwab Center for Financial Research, recommends looking at the next one to three years and adding up any big-ticket stuff you see coming: tuition, a wedding, a down payment on a house. Once you have your total, aim to hold that much in a cash account or a low-risk investment such as a high-quality short-term bond fund.

The truth is, it was always the right idea to put money for near-term, big-ticket items in a safe place. But several things conspired against common sense. First, it seemed fussy and old-fashioned to deny yourself current consumption and future growth by saving when your house and portfolio were appreciating at 10% a year.

Second, the financial services industry encouraged you to think big. Consider the Rhode Island 529 college savings plan managed by AllianceBernstein. Its standard fund for a high school junior had 35% of assets in stocks. It fell 20% in 2008. Assuming you saved four years' worth of tuition... there went most of senior year.

WHAT TO DO: It's not easy to build cash savings and a retirement fund at the same time. If you have to make choices, build up that emergency fund first because you can't expect to lean on your home equity or stocks if you lose your job. And see if you have some flexibility on the big-ticket obligations. Maybe you plan for a state school rather than a private college, or downsize the wedding. If all your assets are in a 401(k), move some of that balance to low-risk investment options as you build your cash funds. That will preserve more to tap via a 401(k) loan in a pinch. Not a terrific option, but it can beat the alternatives.

In the years just before and after retirement, cash becomes even more important. You don't want to sell stocks during a bear market to buy groceries. Aim for two to four years' worth of living expenses in low-risk assets as you near retirement.

Rule No. 3: Human capital

OLD THINKING: The longer your time horizon, the more stocks you should own.

NEW RULE: Time isn't everything. You must also consider your earnings potential.

It's one of the basic rules of thumb: The more years you have to recoup losses, the more aggressive you can be. Unfortunately, the math isn't so clear-cut. Zvi Bodie, a finance professor at Boston University, explains that while the odds of losing money shrink as the years go by, the worst-case scenario - you keep on losing - just gets worse and worse.

If holding stocks for the long run really did make investing safe, Bodie argues, mutual fund companies would gladly guarantee your 401(k) investments. The past decade's returns are a vivid reminder of why they don't.

Here's a better way to think about how aggressive your portfolio should be: Imagine that it includes not only stocks and bonds but also your human capital, meaning your ability to earn income by working. "In most cases your human capital will be your primary asset for much of your life," says Bodie. The safer it is, the more chances you can afford to take with your other assets - that is, your portfolio. Now, this doesn't mean that time no longer matters. When you're young, after all, the value of your earnings potential far outweighs the balances in your 401(k) and other investment accounts. As you age, the value of your human capital declines, and you'll need to secure more of your savings. So the conventional advice to hold a lot in stocks when you are young and gradually trim back can still make sense.

But not for everyone. The nature of your career may make your human capital more bond-like or more stock-like, says finance professor Moshe Milevsky of York University in Toronto. Tenured professors like Milevsky have human capital that resembles a triple-A-rated bond, especially when they have a solid pension plan. Those lucky souls can dive aggressively into stocks and even stay there as they approach retirement, he says. The human capital of a commission-based mortgage broker, on the other hand, is pretty clearly a stock - and it's not a blue chip. That person should own a fair amount of bonds, even when young.

WHAT TO DO: Assess your human capital. A typical worker's income is about 70% like a bond and 30% like a stock, says Thomas Idzorek, chief investment officer for Ibbotson Associates. Use that as your baseline and then think about how long you'll be working, the stability of your current job, and your ability to change careers if you have to. You've probably realized in the past few months that your human capital is not as secure as you once thought. If you've been an aggressive investor, that alone may be a reason to shift more of your assets to safer ground.

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