Monday, March 16, 2009

How The Economic Crisis Challenges Our Financial Beliefs

As the economic crisis deepens, I'm seeing more people beginning to confront the conventional wisdom espoused in personal finance. This economic recession is now in its 15th month, and is pegged as the third longest slump since World War II. People are worried about how business has slowed down drastically over the last 6 months.

Given how financially difficult things have become for so many, I'm starting to notice more and more people questioning the tenets of solid personal finance, at least the way I've come to embrace it. Here are some of those widely accepted rules that are now being questioned.

Personal Finance Theories and Tips Under Siege

Which personal finance teachings are being put to the test right now?

1. Build an emergency fund. Cash is king!

Is your emergency fund big enough? For those of us working to save for a rainy day, I'm now wondering whether the standard six months of living expenses is enough to cover us comfortably. When faced with a painfully long recession as the one we're having right now, I've become more convinced that we need much more than six months' worth of expenses in a safe and liquid high yield savings account. But it depends highly on your personal situation.

With layoffs the norm right now, the emergency fund has become the bastion for so many families currently living on unemployment checks. Those who are able to receive unemployment benefits, which provide 26 weeks of monetary coverage based on where you live and your original pay, plus an extension (of seven weeks for a total of 33 weeks) may have to worry less than those who are not eligible, such as business owners like myself. So how much should you stash in your liquid account? Note that there are numerous ways to build an emergency fund, including the possibility of using forms of credit and non-traditional sources of funds (like a credit card) that I know many folks rely on, but these are solutions I personally wouldn't undertake because of the risks involved. Personally, I expect my emergency savings to cover my family for 18 months, a relatively lengthy period which I've chosen to fit my personal circumstances and comfort level.

2. Stay the course, stay put, and buy and hold.

Why is it that most investors don't make money in the stock market? Because they engage in market timing and own non-diversified holdings. Nevertheless, I'm seeing more and more investors and talking heads proclaim that the buy and hold strategy is passe, that market timing is now the way to go and that we need to prepare for a new financial era that isn't going to be conducive to long term investing. A lot of market traders are now capitalizing on the new economic environment to sell their ideas. Now I think there may be some room in our investment education for stock picking, technical analysis and stock charting tools (for a small portion of our portfolios), but I'd be careful to completely change course simply because of temporary market conditions.

It's unfortunate that this market environment is letting people learn the hard way, that equity investing is not for them. My biggest advice? Whatever you do, try not to act on emotion. Market timing and trading are not for the faint of heart, so be wary of these approaches. If you insist on timing, then do your due diligence and proceed with care. For those searching for some guidance on this matter, here are some thoughts I have on the best places to put your money at this time.

3. Earn an income through your job.

Over time, I've realized that relying on one source of income comes with its own set of risks. If you live in a town that relies on one industry to support its citizens (e.g. Detroit), you can be very vulnerable to heavy downturns like we have now. It's a wise idea to develop diversified income channels, possibly through online activities, alternative investments, freelancing, moonlighting, and entrepreneurial projects that may help support your cash flow needs.

I used to depend largely on my equity investments to supplement my cash flow, but with the market down, it's one more channel that's drying up. Hence, I've been investigating various business and investment opportunities as ways to develop income sources that may help me face tougher financial realities, now that it's become quite clear that working on one lifelong corporate job just isn't that secure.

4. Why rent when you can own your own house?

The American Dream of owning a house may not be all that. Now that we're experiencing a severe housing recession, this dream has become an American Nightmare for a great number of homeowners. The upside down mortgage is now a brutal reality for so many. So should you rent vs buy a house? Make sure you evaluate your options before you commit any money at this time, although acting like a real estate contrarian in today's buyer's market may pay off in the long run. On the other hand, at the rate things are going, I believe that renting for the long term may not be such a bad idea after all!

5. Should we spend our way into an economic recovery?

Mahmohan Singh's stimulus package details strongly emphasize the government's goal: to get the nation to spend. The government has spent lavishly on agriculture, infrastructure and social sector schemes. Personal and corporate income tax rates have been reduced. Our government is telling us to spend money to help jumpstart the economy. But doesn't that go against what's best for ourselves? Shouldn't we be using our stimulus tax credit to pay down our existing debts and to build our savings? Clearly, our financial obligations are to ourselves first. But if we so happen to help our economy along the way, then all the better!

With the nation undergoing such a serious economic crisis, so much of our financial theories and personal financial beliefs are being sorely tested, along with our tenacity and resolve. But we can certainly thank this experience for helping us learn a lot more about finance and the value of risk management, which are especially valuable lessons for those who still have time to make up for losses.

Are your challenging any personal finance theories, have you answers to the questions above? Please let me know by writing in the comment box below.


Devi K said...

Very good article. We can only hope that the economic situation improves very fast. In the meantime we will have to manage our own personal finances and hope for the best.

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