2008 was horrible across the board. What the hell happened and what do I do now?

What happened to those supposedly safe income funds that wound up dropping more then equities? Well, it turns out that they were selling Auction Rate Securities to lever their portfolio positions. These are very short term borrowings that pay low interest rates but are backed by the fund's virtually guaranteed cash flow, so supposedly low risk as well. But in this crash liquidity went out the door and investors fled the instrument simply because there wasn't enough cash in the system to fund all the liquidity the market needed. This left a very large number of income funds with no real ability to renew the money they borrowed, which in turn forced them to sell large chunks of the levered portions of their bond portfolio at very low valuations and destroyed the funds.

If these funds do recover it will be with substantially less leverage at substantially lower yields. Remember, the underlying bonds for the most part only yield 5-6%. It was the leverage that boosted the yield on these funds to 7-9%. The lesson to learn here is that leverage is dangerous no matter how safe the underlying securities. A conservative income investor should not use levered bond funds and expect them to behave the same as unlevered bond funds producing lower yields. The unlevered bond funds (PTTRX and SCTIX would be two examples) for the most part only dropped 10% in the crash.

What have we learned about equities in this crash? The lesson to take home here is that dividend-producing stocks are less risky in a crash and great to hold in a bear market. They went down less and their dividend, even if it was initially a small one (bigger now after the crash), forced a bottom for those securities whereas stocks without dividends went into freefall. Theoretically in a recovery a stock without a dividend (a 'growth' stock) is likely to go up more quickly then a stock with a dividend, but frankly my recommendation here is to stick with stocks that have dividends and control your risk by selecting the dividend rate. That is, a stock with a low dividend still has good growth potential, whereas stocks with higher yields tend to have lower growth potential. It is important to remember that stocks with medium to high dividends still have good growth potential if you reinvest those dividends back into the stock. Off-the-cuff, a stock with no dividend might on average, over 30 years, grow 10% a year, whereas a high-yielding stock with, say, a 5% dividend, might on average only grow 3% a year. But if you were to reinvest that dividend the equivalent growth will be 8% a year. This means that you can still reap most of the benefits of equity growth by chosing less risky dividend-producing stocks and reinvesting the dividend. The one gotcha is that you need to be aware of the tax consequences the dividend represents. It should also be noted when reading my original time-horizon essay (way down below) that you should not be in pure equities at all if you are retired.

Wait, I've retired, I shouldn't be in pure equities? Once you retire you should adjust your portfolio to generate the income you need to live, which generally means that any equities you have should be producing some sort of dividend. If you are not able to live purely off the dividend income coming from your portfolio then you will have to start drawing down the portfolio's basis. It is far better to move to investments which produce the dividends you need to live on then it is to ever draw down the basis in your portfolio. Do not draw down the basis unless you have no other choice, period.

Are money markets safe? Money markets are not guaranteed by the U.S. government but I still feel they are safe. My free cash is still in money markets, not banks.

What mutual funds are safe?. More like what are NOT safe. Most closed-end funds and trusts are not safe. These often suffer from what is called 'NAV erosion', readily apparent if you look at a 4-year graph and see a steady decline even when the general market is good. Bring up a fund on Yahoo, select the max graph, and add the DOW for comparison. If you see NAV erosion then the fund managers are probably padding the yield from the base assets, making the yield numbers look good and also causing the fund to trade at a discount, but it is a fool's game. The NAV erosion means that your actual yield is less and the discount winds up being permanent. In other words, they are just slowly returning your initial investment and charging you for the privilage. Leveraged funds are typically not safe, but with the provisio that if there is no NAV erosion might be a good recovery play now they they have mostly delevered. Unlevered funds are as safe as the underlying securities, but if you still believe in Mutual funds I recommend only going into funds with moderate dividend yields with a proven 5+ year track record and no NAV erosion. DO NOT BUY INTO NEWLY MINTED MUTUAL FUNDS. THESE ARE LIKELY REOPENINGS OF PREVIOUSLY BADLY MANAGED FUNDS THAT WERE SIMPLY RENAMED.

Do I still want to be diversified? YES YOU DO., but you need to understand a few things about diversification. Diversification is NOT 'Growth' verses 'Balanced' verses 'Income' securities or mutual funds. Diversification means sector diversification.. for example, Energy, Foods, Financial, Consumer products, and so forth. In that respect, taking my MLP example above, you would not want to have more then 20% of your portfolio in the energy MLP sector as a whole. Diversification also means risk diversification, and remember that leverage greatly increases risk regardless of the safety of the underlying securities.

I hear a lot about using options to take advantage of the bear market, should I listen? I have heard that using a covered call strategy, where I buy the underlying stock and then sell covered calls on it, is good in this market. I do not recommend it for beginners. In the advanced section I discuss the use of covered calls as a way to aid scaling-into a position. I consider myself a sophisticated investor and I rarely use options. Options are very highly-leveraged (often 10:1) instruments and even the most conservative options strategy -- selling covered calls -- can leave you holding the bag on a stock that drops too low for you to be able to immediately sell it or roll a new option after the option expires. If you do decide to play the game do not jump in head-first. Start slow over a period of, well, a whole year messing with just one or two contracts (each contract has to be backed by 100 shares of the underlying stock), before you invest any substantial amount of money playing this sort of game. If you dive in head-first you will get creamed.

Matthew Dillon