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.

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.

Rule No. 4: Borrowing

OLD THINKING: Borrowing sensibly is a good way to build wealth.

NEW RULE: Borrow cautiously. You have to worry about the other guy's debt too.

The quarter-century leading up to 2007 wasn't simply a golden age for stocks. It was also a bull market for leverage. (That's Wall Streetspeak for debt.) Since 1982, mortgage rates have fallen from 16% to below 6%. The levy on college loans dropped to around 3%. Americans responded to easy credit in a predictable way. The personal savings rate fell from over 12% to zilch, and household debt payments as a percentage of disposable income rose by a third as families "put it on the card" and paid for lavish kitchen upgrades with home-equity loans.

Looking back, America's borrowing binge was nuts. But it didn't feel that way at the time. No less an authority than the chairman of the Federal Reserve didn't see a problem. "The household sector seems to be in good shape," Alan Greenspan said in a 2004 speech, "and much of the apparent increase in the household sector's debt ratios over the past decade reflects factors that do not suggest increasing household financial stress."

Neither Greenspan nor the CEOs of America's banks understood how much families were leaning on housing wealth, or how shaky that wealth was. In the end, much of it was the ephemeral byproduct of ever looser lending rules made possible by Wall Street's wizards, who thought that they had found a way around the risk that a borrower with an (unverified) income of $50,000 would default on a $500,000 home loan.

The obvious moral here is to be conservative. There are always good reasons to borrow, even today. You need a mortgage to buy a house, and a college education provides enough of a lifetime payoff to justify a loan. But you ought to stretch less.

There's a subtler lesson too. David Ellison, president of the FBR Funds, says that you have more exposure to leverage than you think, especially now that everyone is trying to unload debt. Perhaps your employer borrowed a lot over the past decade and now needs to conserve cash, so it's laying off staff. Suddenly that HELOC you could easily handle on your salary doesn't look like such a super idea. You can't lean on your investments for help, because many of the companies you owned used leverage to pump up profits, and now they can't borrow, so their earnings and stock prices are falling. And it's harder to shore up your own balance sheet by selling your house when banks are reining in lending and potential buyers are scared to borrow for an asset that may decline further.

WHAT TO DO: Be conservative about debt? Make that very conservative. Especially when your neighbors aren't. Get a mortgage you can afford for the life of the loan, and put at least 20% down.

Rule No. 5: Housing

OLD THINKING: You can expect your house to appreciate handsomely over the long run.

NEW RULE: Your home won't make you rich. But it is an important savings tool.

If you live on one of the coasts, you probably guessed sometime around 2005 that home prices couldn't keep rising the way they were. But the severity of the crash was still a shock: Even many housing skeptics - never mind the folks at Fannie Mae and the National Association of Realtors - took it for granted that home prices trend upward. You heard a lot near the top about how the market would have to "cool off" or "get back to normal" - the implication being that slow but steady appreciation was the future.

But the long-run data always told a different story. Yale University economist Robert Shiller, who has the distinction of having called the end of both the tech-stock boom and the real estate bubble, looked closely in 2005 at the history of home prices since 1890, using a database he constructed. What he found was surprising. Except for two spectacular booms - the first after World War II and the second starting in 1998 - real estate appreciation has been unimpressive after figuring in inflation. As Shiller wrote in Irrational Exuberance, technology has allowed builders to nail up more houses faster, ensuring that supply never gets too far behind demand (and often gets ahead of it). Likewise, land has never been in short supply in most of the U.S., and when one town gets too crowded, Americans will gladly strike out for the desert or prairie for a bigger house.

Even when prices are rising, gains on real estate aren't as dazzling as they look, once you account for expenses. Maintenance costs typically run at about 1% of a home's value annually, in addition to insurance and taxes. If you remodel, the most you can expect to recoup is about 80%. You have to pay steep fees when you buy (up to 3% in closing costs) and sell (up to 6% for realtor fees).

WHAT TO DO: This doesn't mean you have to rent, just that you should have modest expectations for your house as a wealth builder. There are still financial pluses. First, owning a house gives you a hedge against rising values in your own community so that you don't risk being priced out as rents go up. (Ask a New Yorker about that.) Second, a traditional 30-year mortgage acts as what economists call a "commitment device," or a tool that forces you to save. Instead of writing a check to a landlord, you gradually pay off principal. At the end, you own a house. Aside from your 401(k), no other asset enforces such discipline.

Rule No. 6: Diversification

OLD THINKING: A diversified portfolio lowers your risk.

NEW RULE: Diversification won't always save you - and you need more of it than you think.

Diversification hasn't stopped you from getting hurt in this downturn. Both U.S. and foreign stocks are deep in the red. Holding bonds did cushion your losses, but most kinds of bonds still declined. What happened? Jeremy Grantham, chief investment strategist at GMO, observed back in 2007 that we had a bubble not just in one or two kinds of assets, but in risk. Investors around the world were so confident, and so hungry for even a little extra return, that they were throwing money at anything that might deliver. (Hedge funds got into the movie business, and that should have been a red flag.) Now that the risk bubble has burst, all those investors want now is the safety of U.S. Treasuries. So everything has moved roughly in sync, both up and down, for a few years.

Bear in mind, though, that these times are, to say the least, unusual. Over a longer period - as little as a decade - diversification still looks effective. While large U.S. stocks are down the past 10 years, U.S. corporate bonds earned 4.6% a year for the same period.

But in a global economy where money moves quickly, you have to work harder at diversification than before. Rob Arnott, founder of Research Affiliates, has found that a well-diversified portfolio returned a healthy annualized 6% from 1999 through the end of 2008. Arnott's definition of diversification means a lot more than the usual mix of U.S. blue chips, high-quality bonds, and maybe some big foreign companies. It includes real estate investment trusts, emerging markets, and foreign and junk bonds.

WHAT TO DO: To ensure you are diversified, you don't have to go out and buy 16 new mutual funds. First, look under the hood of the funds you have to see if you already own some of those assets. An easy way to do so is to plug your holdings into Morningstar.com's Instant X-Ray tool. (Click the Tools tab.) And buy funds that kill two birds with one stone. The T. Rowe Price International Bond fund (RPIBX), for example, invests up to 20% of its assets in emerging markets and the rest in developed countries. Put that together with a high-yield fund and a broad U.S. bond fund, and you'll own most of the bond universe.

Rule No. 7: Retirement

OLD THINKING: Retiring early is a prize.

NEW RULE: Retiring early is a problem.

Ever since Uncle Sam set 65 as the age you could retire and collect full Social Security benefits (it's 66 or 67 for boomers today), workers have been trying to beat that bogey by quitting early. Retiring before you hit, say, 60, made sense a generation ago, when average life expectancy was still less than 70 years. (It's 78 today.) And a longer life on the beach seemed well within reach earlier in this decade after a bull market that gave workers confidence that their money could work for them rather than the other way around.

But the reality of early retirement, even before the stock market's sickening plunge, was never quite that rosy. More than half of early retirees leave work before they intended, and of those, nine in 10 depart because they get sick or are downsized. And now the financial prospects for those who had a shot at a secure early retirement have dimmed: Long-tenured workers nearing retirement have seen their 401(k) accounts shrink an average of 30% over the past 14 months, according to EBRI. There's no way around it: The numbers require you to rethink your plans.

WHAT TO DO: "By delaying retirement just one year you could increase your annual retirement income by 9%," says Richard Johnson, senior fellow at the Urban Institute. If you can hang on to your current high-paying post, great. The reality, of course, is that in an era of harsh cost cutting, well-paid older workers are more vulnerable. And you might not want to stick it out any longer anyway if the severance is decent. But there's much to be gained from finding another job, even if it's a lower-paid or part-time position. If you can earn enough to avoid collecting Social Security benefits early or dipping into your retirement accounts, research by T. Rowe Price shows, you'll barely feel a hit to your income when you do retire. If your new job comes with health benefits, so much the better. The average health-care tab for an early retiree before he is eligible for Medicare runs to $8,500 a year, says an AARP study.

Despite all those benefits, if you are still many years away from the retire-or-work decision, you should think of working longer as Plan B. As we noted, you won't have complete control over your ability to work - your health or the job market could make it difficult. That means you can't afford to assume that you'll just work a few more years if things go wrong. You will still have to stick to rules 1 through 6.