Our nation's current financial crisis is the most complicated set of events we could ever dream of.
Banks facilitated the growth in mortgages by assuming house values would continue to rise, the economy would stay strong and provide jobs to new homeowners, and the stack of cards wouldn't fall all at the same time.
Wall Street firms took the mortgages, repackaged them as mortgage-backed securities and made convoluted bets (read gambling, not investing here) on exotic mortgage securities.
For the most part, these securities and the credit swaps that came with them were nothing more than bets, which have now failed for a complex set of reasons.
Many of the failed investment banks went under for reasons that were quite basic and complex.
They collapsed because they forgot the very principles they should be basing their business on such as diversifying and understanding the risks associated with one's investments.
The fact is-the swaps business became so complex, no one understood the risks they were taking.
Here are a few lessons for financial firms-most of which they have been preaching to their customers for years.
Lesson 1: Know how much risk you are taking and remain diversified It wasn't enough to make big bets on what was considered a safe investment-mortgage-backed securities.
In order to stay ahead of the game and increase returns, the failed banks took on obscene amounts of leverage.
Two of the leading investment banks that failed, Lehman Brothers 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 much leverage, the value of the investment would be wiped out if it lost just 4%.
((As individuals we would never take on leverage to that extent.
Yet you could be inadvertently doing the same thing if your retirement funds are concentrated in your employer's stock.
Many employers provide matching contributions to a 401(k) in the form of company stock.
For example, when Bear Stearns collapsed, employees owned more than a 30% of the companies stock.
In a recent survey from Hewitt Associates, a global human resources consulting and outsourcing company, shows that more than a quarter of employees' 401(k) portfolios are in company stock.
Fortunately, you can do something about this without incurring any tax consequences.
Simply adjust your investment mix, by reducing the amount of money held in company stock.
It should be less than 10 percent of the total value of your 401(k) plan.
In many cases, employees are doing just that and are now shifting to a safer mix.
According to the recent data, the amount of 401(k) assets held in equities is at an all-time low, with only 53.
8 percent of assets on average, compared to 68.
1 percent a year ago and down from its high of 74.
2 percent in 2000.
Lesson 2: Don't believe the hype.
Be rational.
Were home prices in many parts of the country in a pricing bubble? Was it possible that home prices could fall substantially? Yes, of course, and given the run up in prices, they had to fall sometime.
Yet financial firms acted as if this could never take place.
Similarly, fund investors seem to be shocked to learn that equities could lose more than a third of their value in a single year.
((In the first half of October, a record $56 billion was moved out of equity mutual funds.
Just because the S&P 500 hadn'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.
This reinforces the advantages of asset allocation and moving more of your money every few years to safer investments.
It is fine to take on risks when you are young, but as retirement years get closer, shift your money following a plan and not when you're in a panic.
Lesson 3: Liquidity is not the same as real money and isn't forever.
Washington Mutual, the large bank taken over by JPMorgan Chase, said in early September of 2008 that it was confident 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.
( (While the run wasn't necessary, it does point out that things change, and can change, overnight.
Your own personal finances, too, can change quickly as the many unemployed Americans can attest.
Cash reserves can evaporate quickly if, for example, you or your spouse are laid off and your primary source of income is reduced.
For consumers, the lesson is make sure you have sufficient reserves to draw on in a crisis.
A rule of thumb is to keep six months of cash stowed away for living expenses.
With the unemployment rate up to 6.
1%, and the US economy in for what looks like a long recession, the prudent strategy would be to build an even larger reserve, perhaps up to a year's worth.
Start now.
Lesson 4: Don't use long-term money for short term problems.
Despite the recent market upheaval and poor investment returns, employees are staying the course and maintaining a long-term focus on retirement saving by continuing to invest in their 401(k) plans.
Like thousands of Americans across this nation, you might be unemployed and tempted to take a withdrawal from your company's 401(k) retirement fund.
Don't.
((First, you are going to need this money at retirement.
Second, taxes and penalties will eat up a good part of your withdrawals.
Third, taking your money out as the market reaches a bottom is the opposite of good financial decision making.
You lose the value of your investment and potentially the timing of the market going back up.
Again according the recent Hewitt survey, the number of employees making trades in their 401(k) plans has risen slightly-19.
3 percent verses 18.
7 percent in 2007-the amount of 401(k) assets being transferred has been significantly higher.
To date, 5.
3 percent of employees' 401(k) savings has been traded, compared to 3.
5 percent in 2007.
In October 2008 alone, 1.
25 percent of employees' 401(k) balances were traded-almost three times the historical average.
What's alarming is a significant increase in the number of investment transfers immediately after the market dropped.
In the vast majority of cases, employees who impulsively respond to the fluctuations of the market dramatically reduce their overall retirement savings since employees are less likely to readjust their investment portfolio when the market makes a turn for the better.
Therefore, it's important to keep in mind that retirement saving is a long-term strategy.
((Further, tight economic times are prompting more employees to tap into their retirement savings in the form of hardship withdrawals.
The data shows an uptick in the number of employees tapping into their 401(k) plans.
More than 6.
0 percent of employees withdrew money from their 401(k) plans in 2008, up from 5.
4 percent in 2007.
The increase is due to an upsurge-16 percent-in hardship withdrawals.
Some firms, in industries that have been especially hard-hit by the economy, have been experiencing hardship withdrawals in excess of 10 percent of their population, which is nearly nine times more than the average 401(k) plan.
Interestingly, 401(k) loan activity has remained consistent with 22 percent of employees currently having a loan outstanding.
((Because the credit crisis has made borrowing from financial institutions more difficult, more employees turn to their 401(k) plans to get the money they need.
It's unfortunate employees are turning to hardship withdrawals instead of 401(k) plan loans, because hardship withdrawals are subject to penalties and additional income taxes that can dramatically and permanently erode employees' future retirement dollars.
(What's more, workers are not allowed to contribute to their 401(k) plan for six months following the hardship withdrawal.
Loans, on the other hand, enable employees to borrow money, penalty-free, and more importantly, continue to make contributions to their 401(k).
Ongoing contributions ensure workers gain the benefit of employer matching contributions, which significantly aid in savings growth and are critical to reaching retirement goals.
Banks facilitated the growth in mortgages by assuming house values would continue to rise, the economy would stay strong and provide jobs to new homeowners, and the stack of cards wouldn't fall all at the same time.
Wall Street firms took the mortgages, repackaged them as mortgage-backed securities and made convoluted bets (read gambling, not investing here) on exotic mortgage securities.
For the most part, these securities and the credit swaps that came with them were nothing more than bets, which have now failed for a complex set of reasons.
Many of the failed investment banks went under for reasons that were quite basic and complex.
They collapsed because they forgot the very principles they should be basing their business on such as diversifying and understanding the risks associated with one's investments.
The fact is-the swaps business became so complex, no one understood the risks they were taking.
Here are a few lessons for financial firms-most of which they have been preaching to their customers for years.
Lesson 1: Know how much risk you are taking and remain diversified It wasn't enough to make big bets on what was considered a safe investment-mortgage-backed securities.
In order to stay ahead of the game and increase returns, the failed banks took on obscene amounts of leverage.
Two of the leading investment banks that failed, Lehman Brothers 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 much leverage, the value of the investment would be wiped out if it lost just 4%.
((As individuals we would never take on leverage to that extent.
Yet you could be inadvertently doing the same thing if your retirement funds are concentrated in your employer's stock.
Many employers provide matching contributions to a 401(k) in the form of company stock.
For example, when Bear Stearns collapsed, employees owned more than a 30% of the companies stock.
In a recent survey from Hewitt Associates, a global human resources consulting and outsourcing company, shows that more than a quarter of employees' 401(k) portfolios are in company stock.
Fortunately, you can do something about this without incurring any tax consequences.
Simply adjust your investment mix, by reducing the amount of money held in company stock.
It should be less than 10 percent of the total value of your 401(k) plan.
In many cases, employees are doing just that and are now shifting to a safer mix.
According to the recent data, the amount of 401(k) assets held in equities is at an all-time low, with only 53.
8 percent of assets on average, compared to 68.
1 percent a year ago and down from its high of 74.
2 percent in 2000.
Lesson 2: Don't believe the hype.
Be rational.
Were home prices in many parts of the country in a pricing bubble? Was it possible that home prices could fall substantially? Yes, of course, and given the run up in prices, they had to fall sometime.
Yet financial firms acted as if this could never take place.
Similarly, fund investors seem to be shocked to learn that equities could lose more than a third of their value in a single year.
((In the first half of October, a record $56 billion was moved out of equity mutual funds.
Just because the S&P 500 hadn'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.
This reinforces the advantages of asset allocation and moving more of your money every few years to safer investments.
It is fine to take on risks when you are young, but as retirement years get closer, shift your money following a plan and not when you're in a panic.
Lesson 3: Liquidity is not the same as real money and isn't forever.
Washington Mutual, the large bank taken over by JPMorgan Chase, said in early September of 2008 that it was confident 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.
( (While the run wasn't necessary, it does point out that things change, and can change, overnight.
Your own personal finances, too, can change quickly as the many unemployed Americans can attest.
Cash reserves can evaporate quickly if, for example, you or your spouse are laid off and your primary source of income is reduced.
For consumers, the lesson is make sure you have sufficient reserves to draw on in a crisis.
A rule of thumb is to keep six months of cash stowed away for living expenses.
With the unemployment rate up to 6.
1%, and the US economy in for what looks like a long recession, the prudent strategy would be to build an even larger reserve, perhaps up to a year's worth.
Start now.
Lesson 4: Don't use long-term money for short term problems.
Despite the recent market upheaval and poor investment returns, employees are staying the course and maintaining a long-term focus on retirement saving by continuing to invest in their 401(k) plans.
Like thousands of Americans across this nation, you might be unemployed and tempted to take a withdrawal from your company's 401(k) retirement fund.
Don't.
((First, you are going to need this money at retirement.
Second, taxes and penalties will eat up a good part of your withdrawals.
Third, taking your money out as the market reaches a bottom is the opposite of good financial decision making.
You lose the value of your investment and potentially the timing of the market going back up.
Again according the recent Hewitt survey, the number of employees making trades in their 401(k) plans has risen slightly-19.
3 percent verses 18.
7 percent in 2007-the amount of 401(k) assets being transferred has been significantly higher.
To date, 5.
3 percent of employees' 401(k) savings has been traded, compared to 3.
5 percent in 2007.
In October 2008 alone, 1.
25 percent of employees' 401(k) balances were traded-almost three times the historical average.
What's alarming is a significant increase in the number of investment transfers immediately after the market dropped.
In the vast majority of cases, employees who impulsively respond to the fluctuations of the market dramatically reduce their overall retirement savings since employees are less likely to readjust their investment portfolio when the market makes a turn for the better.
Therefore, it's important to keep in mind that retirement saving is a long-term strategy.
((Further, tight economic times are prompting more employees to tap into their retirement savings in the form of hardship withdrawals.
The data shows an uptick in the number of employees tapping into their 401(k) plans.
More than 6.
0 percent of employees withdrew money from their 401(k) plans in 2008, up from 5.
4 percent in 2007.
The increase is due to an upsurge-16 percent-in hardship withdrawals.
Some firms, in industries that have been especially hard-hit by the economy, have been experiencing hardship withdrawals in excess of 10 percent of their population, which is nearly nine times more than the average 401(k) plan.
Interestingly, 401(k) loan activity has remained consistent with 22 percent of employees currently having a loan outstanding.
((Because the credit crisis has made borrowing from financial institutions more difficult, more employees turn to their 401(k) plans to get the money they need.
It's unfortunate employees are turning to hardship withdrawals instead of 401(k) plan loans, because hardship withdrawals are subject to penalties and additional income taxes that can dramatically and permanently erode employees' future retirement dollars.
(What's more, workers are not allowed to contribute to their 401(k) plan for six months following the hardship withdrawal.
Loans, on the other hand, enable employees to borrow money, penalty-free, and more importantly, continue to make contributions to their 401(k).
Ongoing contributions ensure workers gain the benefit of employer matching contributions, which significantly aid in savings growth and are critical to reaching retirement goals.
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