Net Gains: Investing in a Post-Bear Stearns World

March 18, 2008 — -- I'm not smart enough to know what happens next with the world's markets after the swift downfall of investment bank Bear Stearns.

Are we in for prolonged financial crisis? Or will we put the current turmoil behind us quickly?

I don't know, and I'm not sure the smartest minds in finance know either.

But I do know the folks on Main Street are worried about what's happening on Wall Street these days. They know trouble when they see it, and they see it in smaller 401(k) balances, foreclosure notices and a falling dollar.

They wonder about what they should they do in response?

"Should I yank everything out of stocks?"

"Should I dump my bond fund that might contain bad mortgage debt?"

"Should I buy euros? Or just stuff cash into a safe-deposit box?

My first advice, of course, is to avoid panic and do nothing extreme like moving all your stock holdings to cash. Very likely that would mean you'd be selling low, buying high when markets recover and in the meantime earning a dismal return on cash as the Federal Reserve continues its rate-cutting campaign.

But worry about the current state of the financial markets is quite understandable. "Do nothing" is tough advice to follow in times like these.

So if you're worried about what the pennies-on-the-dollar sale of Bear Stearns will mean for you and you feel a need to act let me suggest some modest measures.

Pay down debt: Few things will allow you to withstand tough economic times like a low debt load. A strong personal balance sheet with assets well in excess of liabilities can help you weather the worst financial storm. The lower your loan balance, the less pressure you will feel from monthly interest payments.

In addition, paying down a fixed-rate loan provides a guaranteed rate of return that can be quite comforting during times of market turmoil. Your auto loan might only carry a 5-percent interest rate, but that looks pretty good right compared to the 3.5 percent you might get on a bank CD or to current stock market uncertainty.

And if you're in a variable rate loan, now is the time to pay it down as the Fed's recent rate-cutting moves means you get more bang for your buck. With each dollar you pay as rates decline, more goes toward paying down principal and less toward interest.

If there have been any beneficiaries from current economic conditions, they are borrowers with home equity lines of credit who maybe let their balances grow too high when it looked as if real estate values could only go up.

Bring that balance under control before rates start rising again.

Go international: Some worried investors view the decline of the dollar, falling real estate values and large holdings of U.S. government debt by China as sure signs we're a nation in economic decline.

If you're a pessimist in that camp, then consider allocating a larger share of your portfolio to international investments. In a globalized economy, it is a good idea to be invested overseas regardless of your opinion of the U.S. future as an economic power.

For those who think the dollar may never recover, investments in mutual funds specializing in foreign stocks, bonds or REITs can be a smart way to address your concerns.

A falling dollar can enhance the returns that U.S. investors receive on foreign investments. That is because as the U.S. dollar falls in value, returns earned in other currencies translate into more dollars. Just be aware that the opposite also is true, a rising dollar can hurt your returns on your international investments.

Whatever the dollar's direction, there are many benefits to international investing. Just don't get carried away. What I would not advise the average investor to do is start making currency bets or buying up currency-focused mutual funds or exchange-trade funds. Leave that to George Soros and Warren Buffett.

Avoid concentrated bets: There's a certain class of investor who will view the mortgage meltdown as an opportunity to buy good investments on the cheap. They may look to mutual funds or ETFs that focus on the financial services or REIT sectors, both of which took a pummeling over the past year.

That's not a bad strategy for those who can live with high levels of risk. Just don't go overboard. Keep it to maybe 5 percent of your overall portfolio.

Stay diversified: The flip side of avoiding concentrated bets is the need to remain diversified no matter what happens next. I can't tell you what the best-performing asset class will be in the next one, five or 10 years. But I can tell you will lower your risk and stand a better chance of scoring respectable returns by investing across a variety of asset classes, from small- and large-cap U.S. stocks to domestic and foreign bonds to even overseas real estate and natural resources.

Find extra income: This suggestion may not go over well, but those worried the current turmoil means we're in for an extended bear market should consider finding ways to make more money. If you've thought about taking on a second job -- even for a brief period -- now may be the time.

For those in the early years of retirement, even a modest part-time job can go a long way toward extending your portfolio's life span. An extended stock market decline can be particularly devastating to those who have retired recently. But an extra $10,000 or $15,000 income for a few years can make a huge difference.

None of these suggestions guarantee an average investor won't take a hit from the conditions that knocked out Bear Stearns, but they can cushion the blow for those of us worried about what comes next. I'm smart enough to know that.

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

David McPherson is founder and principal of Four Ponds Financial Planning (www.fourpondsfinancial.com) in Falmouth, Mass. He previously worked as a financial writer and editor for The Providence Journal in Rhode Island. He is a member of the Garrett Planning Network, whose members provide financial advice to clients on an hourly, as-needed basis. Contact McPherson at david@fourpondsfinancial.com