The market went down, and some ran (they always do).

And then it went down more, and more ran (”this time it’s different!”).

Then it went up.

So, how will you invest now?

And more importantly, what was your plan back then?  How did it hold up?

Ready to learn something about yourself that will affect your investing philosophy and style for the rest of your life?  Let’s take a careful look at the last two years with respect to your portfolio - a ride through unprecedented times.

Earlier in 2009, it was a scary and dark time in the markets.  There was so much uncertainty that I suggested you review your financial worst case scenario.  No one knew it at the time, but it was actually the beginning of an excellent run in the stock markets (DOW JONES up about 30%).  In the following months, the financial industry came out of it’s total eclipse, credit markets began to open up, and portfolios began their turnaround.  But how did YOU fare?  It all depends on the actions you took in those critical few months.  30% up doesn’t matter if your position was primarily “fetal and 100% in cash“.

The events of 2008 and 2009 provided a rare chance to take a real look at your risk tolerance.  Did you end 2007 saying “I’m young so I’m an aggressive investor and can handle 100% in stocks”, only to end 2008 by selling everything, withdrawing the cash and going to sleep each night clutching every last dollar bill?  Maybe you felt like doing that, but hopefully you didn’t follow through.  What is important is that you look back at those feelings, how they affected your actions, and how it impacted your financial situation.

If hindsight reveals that you made mistakes, maybe it shows you didn’t have a plan, or didn’t stick by it.  I (luckily) stuck with my investing plan of staying in the market, continuing my regular investments, and re-balancing against my asset allocation, and it worked out for me… but it wasn’t without some strife!

I had a discussion with a colleague about his investing strategy in the heat of the mess, in early 2009.  I explained my (simple, well understood) strategy of regularly investing and re-balancing my portfolio, and he said “but don’t you think something different is happening here?”  He could not believe that I was “doing nothing”.  Given he’s a pretty smart guy, this was a gut check for me.  But in the end I realized it: sticking by your asset allocation and investing plan IS DOING SOMETHING.  In fact, it’s a strategy that’s been proven time and time again to work in any market scenario.

Psychology can have a profound impact on your investing success.  The best way I’ve found to combat the roller-coaster that is the market is to have a plan.  What is your plan?  What did you learn about yourself in the last two years?  How will you invest now as a result?

If you need help creating an investing plan, I recommend the following:

• Learn about asset allocation.  Start with this article from about.com.
• Decide on your risk tolerance.  See my post on the topic for some ideas.  The book below will offer some help as well.  Don’t obsess over getting this exactly right the first time, you can always adjust it as you go!
• Read The Smartest Investment Book You’ll Ever Read by Daniel Solin, which will tell you everything you need to know about investing in index funds, buying the right funds, setting your asset allocation, and rebalancing it.  It’s an excellent read and not that long or technical.  Learning the simple principles covered in this book will change your investing future forever - for the better.
• Setup automatic investments - this is the best way to keep your plan on track despite your procrastination and forgetfulness.  You should start by maximizing your 401(k) contribution at work (to minimize your income taxes), and then investing outside that account in a regular brokerage account. Just make sure that your automatic investments aren’t costing you fees - most brokerages (like Fidelity, Vanguard, Schwab) don’t charge for automatic investments.
• Check your asset allocation annually, and rebalance.  Remember to not watch your investments too much!

A parting thought - having an investing plan is not the whole story - make sure you have a life plan as well, with good financial goals.  Know WHY you are investing.  Take a look at my original posts on how to do it.

photo: crystaljingsr

MoneyMerc is dedicated to “little decisions” that make a big impact.  Our little decision for today is to make sure you know your financial worst case scenario.  These are uncertain times - but the time to plan for the worst case is before you are living it.  Of course everyone’s situation is different, and no one can predict the future… but the goal of this post is to get you thinking about your own situation to prepare you for the unknown.  Don’t get scared - get ready!

A short list of (probably) the worst events for your financial situation:

1. Losing your job (or spouse’s)
2. Death of a primary income earner in your family
3. Parents losing their job or income if they are retired (and start to depend on you)
4. An unforeseen immediate medical need, either of you, a family member or parent/grandparent
5. Other large expenses you didn’t plan for (a new child, natural disasters which you don’t have insurance for, etc.)

If any of these occur, in most cases the crux of the situation is cashflow.  Here are some things to consider:

What’s in your personal bailout fund?

Everyone needs a bailout sometime - unlike Wall Street, most people have to work it out for themselves.  Otherwise known as an emergency fund, your personal bailout fund should be easy to access, and 100% safe.  A bank savings account is a great place for this money, because you can walk into your bank on any given day and walk out with the cash.  Other forms of investments like stocks or funds are not good to use (you might be forced to sell when they are down) - ditto for anything that takes more than a day or so to get your money.  If you are lucky enough to have parents or family who can loan you money quickly, that is technically another option for you - IF you can look at yourself in the mirror owing them money.  But don’t relay on that if you haven’t previously discussed the possibility with them, because that wouldn’t count for knowing your worse case scenario.

How big are your bills?

Most people don’t have a full understanding of where their money goes each month.  Bills fall into two categories - those that are essential for living (mortgage payment, basic food expenses) and those that are non-essential but improve living (dinner out, starbucks, new electronics).  Make sure you know exactly what amount of money goes out each month to the essential (”non-discrentionary”) expenses.  It can be an eye-opening experience to divide your emergency fund total balance by your essential expenses.  Ideally this ratio will be 3 to 6 months.  Meaning if you lose your job, you can survive for that long.  With a job market like today, go for 6 months or more if you can.  If your ratio number is less than one, you should start worrying, and then make another little decision to start figuring out how to decrease your expenses.

If you are married and both work, then you should also ask yourselves if you can afford your required expenses on a single income.  Which leads us to…

How secure is your job?

Take step out of your cube, turn around, and look back at your empty desk.  What if you didn’t sit there anymore?  Carefully consider the likelihood of losing your job.  It’s scary to think about, but it’s also easier to work on skills and generally prepare for another job while you have a current source of income.  Think about what industry you work in, and the general stability of other companies in the same industry or of similar size.  Why is your company more secure than others, and why is your job more secure than the person next to you (or than even your boss)?  Is it really?  Keep in mind and try to avoid the human bias which makes us think we are better than we really are (watch the first few episodes of American Idol each season to understand how this works!)  And check out Get Rich Slowly’s 10 Essential Steps to take before you get laid off.

How much debt do you have?

I’m not so worried about mortgages and student loans here - but you should be well aware of how much you owe on your credit cards, and at what rates.  Paying off debt is your financial job #1.  But if you don’t have an emergency fund, it may be wise to start building one before paying off debt. But you definitely don’t want to be in a situation where you can’t afford even your minimum payment.

So what’s the next step?

Now that you’ve thought about your own situation, what is your takeaway?  What one thing can you do to make sure your worst case is a little less worse?  Do you need to get help with your debt?  Or just force yourself to remember to save by setting up an automatic savings plan?  Maybe start talking with your parents about the security of their own financial situation so you can better know how it may affect you?

photo credit - joelogon

(photo: Dave Malkoff)

An Exchange Traded Fund (ETF) is similar to an index fund - they are typically not actively managed and therefore (often) have low management fees.  Sometimes when you can’t find the perfect fund for your asset allocation, an ETF will fill that gap.  But ETFs aren’t good for regular automatic investments, because you pay a trading fee each time you buy or sell, just like you would in a stock.  Also, they have other supposedly good features which are useless to regular investors:  you can sell them short, and you can trade them during the day (rather than only once per day with a fund).   Because of these features (and marketing), ETFs have gained popularity in the last couple years, and the flavors available have proliferated.

In watching your portfolio drop in the last year, if you are like most people you are wondering where you can invest your money so it’ll go UP, not DOWN.  Check out the finance.google.com page on most recent days, and you’ll see on the “Top Movers” list is the “ProShares Ultrashort Financials ETF”.  On 3/13 it gained 10% when the Dow was down 1.7%, and I’ve seen it gaining 30% or even 50% in a single day.  So you’re thinking, wow, I need to get a piece of THAT!  It’s a perfect hedge for your portfolio, since when the rest goes down, this goes up… right?

Not so fast.  This ETF is part of a certain class of ETFs which are very risky, volatile investments and shouldn’t be purchased by regular investors like you.  These ETFs have words in the name like: “ultrashort, double, triple, 2x, 3x, bear, bull”.  Something that is “2x”, for example, is designed to return 2x what regular investors would get in the underlying investment (e.g. a “2x S&P500″ ETF will gain 2x the S&P on up days, and lose 2X the S&P on down days.)  How do they do it?  All of these ETFs employ “leverage” to give the prescribed return profile, which means they borrow money so they can invest more.  It’s like investing on margin for regular investors - say you have $1000 to invest, but can borrow another $1000, allowing you to invest $2000.  So that when it goes up 10% to $2200, you give back the $1000, and made $200 or 20% (minus borrow cost) on an investment that only went up 10%.  On the flip side, if the investment goes down 10% to $1800, you still have to give back $1000 and now lost 20% (plus borrow cost) on an investment that only lost 10%. (Lesson: don’t invest on margin.)

Okay you say, but what if I use one of these as a small PART of my portfolio, as a hedge (like owning stocks and bonds together - one goes up, the other down)?  As Jason Zweig from the Wall Street Journal writes, this strategy can (will) backfire.  Due to the large swings in daily holdings values, leveraged ETFs are not designed as long-term investments.  They are for day traders, not investors.  For one example, on Friday the lovely ProShares UltraShort Financials had 31.92million shares traded - but it only has 6.8 million shares outstanding!  This implies an average hold time of 86 minutes.  The article quotes Andy O’Rourke, marketing chief of Direxion Funds, an ETF manager - holding a leveraged ETF longer than a day is “like using a toaster to cook a turkey.”

As usual in investing, you will be rewarded by sticking with the basics and not experiementing.  Reducing ‘oops’ moments will make you richer.

Have any thoughts on ETFs?  Please tell us about it in the comments.