5 lessons from the crash

(Money Magazine) -- Even one year later, the speed with which America's financial system unraveled last September still boggles the mind.

The worst financial meltdown since the 1930s began, you'll recall, with a bang. Early in the month the housing crash led to the federal government's takeover of mortgage giants Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500) -- whose dividend-paying stocks were a cornerstone of many retirement portfolios.

Within days the crisis had spread to the investment banks. Lehman Brothers soon collapsed under the weight of its bad mortgage-backed bets, while Merrill Lynch was forced into the hands of Bank of America (BAC, Fortune 500).

Then came news that insurance giant AIG (AIG, Fortune 500) faced a credit crunch, leading to an $85 billion government bailout (which turned out to be a first installment). The Bush administration, led by Treasury Secretary Hank Paulson, hastily crafted a Wall Street relief package that was initially rejected by Congress. The Dow plunged nearly 780 points on its way to an eventual 5,000-point rout.

This year the index has climbed about halfway back, thank goodness. But don't allow the recent rebound to make you forget the pain. Even if the worst of the crisis is over, that which didn't kill your nest egg can make you smarter about your investments.

And while your portfolio is still weaker than it was a year ago, the five following lessons from the Crash of '08 will help you strengthen your finances going forward -- and should limit the damage in the next crisis, wherever and whenever it may come.

Lesson 1: Asset allocation still works -- just don't expect a guarantee.

In the wake of the crash, you may have concluded that asset allocation -- the traditional strategy of diversifying among stocks, fixed income, and cash -- is a bust. After all, your U.S. and foreign equities and all sorts of bonds lost money last year.

"The basic principles of asset allocation need to be revised," says MIT finance professor Andrew Lo. He and other experts argue that since market volatility is rising, you must now own other assets -- such as hedge-fund-like investments -- in addition to stocks and bonds to manage risk. And you must be prepared to shift your mix tactically from time to time. "You need to be proactive and adjust as the market changes," he says.

Lo is correct that it's harder to diversify today (we'll get to that in a moment). But the argument that to reach your goals you must rely on new tactics downplays two big lessons of history -- one recent and the other long established.

The first: Many alternative investments such as hedge funds took a beating in the crisis. And in the long run, the evidence is overwhelming that investors who try to time the market generally fail to beat those who don't. As Warren Buffett says, "The stock market has a very efficient way of transferring wealth from the impatient to the patient."

The real problem with asset allocation isn't that it no longer works, but that people expect that it will always work. And that's just not true. The 2000-02 bear showed that even sophisticated asset allocations can't guarantee you won't lose money in a lousy market. "That doesn't mean asset allocation is a bad idea," says Harvard economics professor John Campbell. "If vaccines don't work for swine flu, it doesn't mean you shouldn't vaccinate for other types of flu."

And if you look at the numbers, you'll see that proper diversification did you considerable good in this meltdown. Yes, most stocks and many fixed-income categories rang up huge losses. But long-term U.S. Treasuries gained more than 27% last year (see the chart at right). High-quality U.S. corporate and global bonds also made money -- as did cash.

If you held a mix of 35% U.S. stocks, 25% foreign stocks, 10% cash, and 30% fixed income (including government and high-quality corporate bonds), you would have lost just 28% between Sept. 1, 2008, and the market's bottom of March 9. By comparison, the S&P 500 was down nearly 50%.

Lesson 2: The world is riskier -- and will stay that way.

Remember the Great Moderation? The phrase describes the recent quarter-century period when economic growth looked limitless and the long-term risk in stocks seemed to be disappearing. Between 2003 and 2007, for example, the Chicago Board Options Exchange Volatility Index (VIX) (VIX) -- a well-known gauge of how risky investors think the market is -- hovered in the 10-15 range. That was down considerably from the index's historical average of about 20.

Risk, of course, returned with a vengeance. Last October, at the height of the banking crisis, the VIX hit an all-time high of 80. At those levels, a conservative portfolio that held 30% in stocks and 70% in bonds would bounce up and down the way a 60% stock/40% bond portfolio did before the market meltdown.

Today the VIX has fallen back to around 25. The question is, should you brace yourself for more nerve-jangling spikes? Yes, according to many investment pros, including Yale finance professor Roger Ibbotson, founder of Ibbotson Associates.

He expects the market to remain jittery for several years. Blame the unstable economy, which is likely to deliver more corporate earnings disappointments, and shell-shocked investors who are likely to react sharply to any bad news. "Given the higher volatility today," says Ibbotson, "you may need to ratchet down the risk in your portfolio."

That doesn't mean you should reverse your 60% stock/40% bond portfolio, or that you should do something even more radical. Instead, revisit your investment mix to make sure you're taking on an appropriate amount of risk in light of your financial goals and your tolerance for more market shocks.

Studies show that most of us, not surprisingly, think we can handle more risk when the market is rising than when it's falling. That makes last year's plunge an ideal stress test, says Michael Schlachter, managing director at Wilshire Associates. So ask yourself, How well did I handle it? If you were gulping down Xanax, cut back your stocks by five or 10 percentage points while boosting your fixed-income allocation.

By easing back on equities to accommodate a slightly greater weighting in bonds and cash, you sacrifice some potential return. But not as much as you might think.

Over the past 30 years, a 70% stock/30% bond portfolio gained just two-tenths of a point less a year than an 80%/20% mix. Yet it would have lost less in the downturn. And if smaller losses keep you from undoing your long-term plans in a crisis, that may be well worth the cost.

Lesson 3: Real diversification is harder to achieve than it looks.

As AIG, Lehman, and other financial giants teetered on the edge last fall, you learned to your unpleasant surprise that Wall Street's woes were dragging down your Main Street portfolio.

Say you were the conservative type who likes funds focusing on low-priced stocks that pay dividends. Well, the typical large-stock "value" fund held more than 30% of its assets in financials before the crisis. Even S&P 500 index funds had as much as a 20% stake in banks, brokerages, and insurers (about twice the current level), since they had grown into a huge part of the market in the credit boom.

As for that bond fund delivering above-average yields, it likely held an above-average helping of subprime mortgage bonds. "People were loading up on the most speculative assets but didn't realize it," says Ibbotson chief economist Michele Gambera.

The best way to avoid too much exposure to any industry or asset -- especially frothy ones -- is to drill down in your portfolio to see what you actually own. Use the Instant X-ray tool at Morningstar.com, which will show how much your funds' holdings overlap and whether your portfolio tilts heavily toward one industry or style.

Another idea: Stick to index funds. As noted, an S&P 500 or total stock market fund can't keep you from getting caught up in the market's momentum. But it's always clear what index funds own, because they mirror well-known benchmarks for which information is readily available.

And you can use a combination of index funds to tack against the tide. Say technology stocks, which are zooming now, start to account for a huge portion of the S&P's market capitalization as they did in 19982000. You could shift some of your holdings to an S&P 500 value index fund, which holds less than 8% of its assets in tech.

Of course, owning different stock funds -- be they actively or passively managed -- won't adequately diversify you, since most equities are positively correlated. Translation: They tend to move in the same direction. And correlations among assets have been growing, as global markets are now intertwined.

That's why you must own high-quality bonds -- especially safe U.S. Treasuries and inflation-protected TIPS bonds, says Gambera. They're often negatively correlated with stocks, so they zig when stocks zag. And you should own foreign bonds to diversify your domestic ones.

Lesson 4: Recognizing a bubble is hard. Hedging against one is harder.

"To spot a bubble in advance requires a judgment that hundreds of thousands of informed investors have it all wrong," said then-Federal Reserve chairman Alan Greenspan in 1999. He should know how hard that is: He failed to detect two of history's frothiest markets -- in tech stocks and in housing.

Then again, how many of us paid attention when Yale economist Robert Shiller -- who correctly called the Internet bubble -- started warning that homes were wildly overvalued?

Given how hard it is to shield yourself from the fallout of a bubble, you may be tempted to try alternative investments, such as long-short funds, which attempt to hedge against the market.

One type, absolute-return funds, aims for positive results in any environment. So-called market-neutral funds seek to beat Treasury bills while remaining uncorrelated with stocks. But in 2008 the typical long-short fund fell 15%, while some lost nearly 40%. When bubbles burst, you can run but you can't totally hide.

The one sure hedge: a healthy dose of cash, an asset all but forgotten during the boom. Don't ignore it now.

Lesson 5: You can't time the market, but you can time yourself.

While you can always find a few savvy folks who have managed to outguess the market, Buffett points out that the vast majority of us fail miserably at market timing.

That said, you should always be timing your own circumstances. Every year that passes is another year you get closer to retirement. Over time this will require you to dial back the percentage of your nest egg that you hold in equities. Yet heading into 2007, nearly 40% of workers ages 56 to 65 held 80% or more of their 401(k)s in stocks. A less stock-heavy portfolio would have been far more appropriate -- and safer.

Then there are circumstances specific to you and your family. Sure, your allocation may have been right when you last rebalanced your portfolio. But what if your employer has run into financial problems recently and you fear losing your job? What if your spouse is coping with a medical emergency, or you're now financially responsible for an aging parent?

If you're dealing with these kinds of situations, it's more important to preserve your principal and build up some additional cash reserves than to earn the highest possible returns. In that case there's nothing wrong with shifting some of your equities into safer, more liquid investments.

This is not a repudiation of asset allocation, but a recognition that your life has changed. And it's that kind of timing that will guide your portfolio safely through good times and bad