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The best ways to protect your money

 The best ways to protect your money
You face 4 big risks in this economy. Here's how to hedge against them - no heavy-duty locks required.

By George Mannes, Money Magazine senior writer
Last Updated: April 8, 2008: 6:01 PM EDT

(Money Magazine) -- Everywhere you look, bad news abounds. The falling stock market, the floundering economy, tumbling home values, vanishing jobs - it's enough to make you want to hide your money in a lockbox and throw away the key.

Don't. "The last thing you want to do is panic on short-term economic news," says Houston financial planner Tom Jackson. "That could have dreadful long-term results." Still, it's not imprudent to tweak part of your portfolio to hedge against the four worst risks - let's call them the Four Horsemen of the Subprime Apocalypse.

Such hedges may not come cheap, since everyone wants the same protection these days. But they can buy you the peace of mind you need to keep the bulk of your money in the game.

Inflation Consumer prices are already rising 4% - more than double the rate in early 2004. As the Federal Reserve slashes interest rates to keep the financial system afloat, it could be building the base for more inflation in the future.

Recession They denied it after the real estate bubble burst, but now more than 70% of economists think recession is here. Odds are that it will be mild, but some warn that it could be among the worst in 40 years.

A dollar collapse The greenback has lost nearly half its value against the euro. And with the U.S. economy slowing and rates falling, there's less reason for the world to buy dollars. That could sink the buck further still.

The credit crunch Burned by all those bad loans they made, banks have begun turning away borrowers - even good ones. The risk is that you might need a loan and not be able to get one at a decent rate.

Risk #1: inflation

It doesn't take a genius to figure out how inflation threatens your family's finances. All you have to do is open your refrigerator to be reminded that milk costs you 13% more than it did a year ago or fill up your gas tank to see that prices at the pump are 33% higher than they were at the start of last year.

Inflation doesn't have to reach epic proportions to have a debilitating effect on your family's purchasing power - or your investments, for that matter. When inflation surpasses 4% - and keeps on rising - big stocks have generally declined in value, says Sam Stovall, chief investment strategist at Standard & Poor's Equity Research.

With inflation now at that magic number, this is a critical juncture for your portfolio. And if you're a bond investor, inflation is your mortal enemy, since it eats away at the value of your yields.

Think back to the '70s, when government bonds returned 5.5% while inflation was growing 7.4% a year. Treasury Inflation-Protected Securities are supposed to neutralize this problem for bond investors. But inflation worries - and demand for easy-to-sell government bonds - have driven prices so high that TIPS maturing within a few years have effective yields hovering around zero.

At these levels, many buyers are simply paying for the privilege of knowing that if inflation soars they're guaranteed to do better than investors in traditional Treasuries, which don't offer inflation protection. (Bond investors can find better deals today in municipal issues, which carry bargain prices.)

The best hedge: a natural-resources fund
As for stocks, a traditional hedge against inflation has been natural resources. Reason: Fuels, minerals and agricultural goods have a certain amount of usefulness no matter what. You still need wheat to make bread, and your grocer will sell you a loaf if you slap down a gold coin.

But since commodities don't throw off interest or dividends, their price on any given day is just a guesstimate of future supply and demand. And because they've shot up tremendously in short order (gold went from $800 an ounce in December to past $1,000 at one point in March), they carry substantial risks of their own.

The stocks of companies that mine, farm and drill for these commodities haven't rocketed as quickly. That's one reason you're better off in a fund like T. Rowe Price New Era (PRNEX). This Money 70 stalwart invests in oil and natural-resources companies such as ExxonMobil (XOM, Fortune 500) and Schlumberger (SLB) - not in the commodities themselves.

The fund has risks, of course. It has gained nearly 30% a year for five years; if oil prices fall and inflation subsides, you could lose money buying in at this level. So understand what you're getting with New Era: not a chance to win big but insurance against the risk that inflation will get worse.

If peace of mind is worth it to you, shift about 5% of your stock portfolio from other large-caps to the fund. That's enough for insurance but not so much that you're betting your future on commodity stocks.

Risk #2: a recession

The biggest risk you face if the current economic downturn sinks into an official recession (loosely defined as six or more consecutive months of a shrinking economy) is not to your stock portfolio. It's that your biggest asset, your earning power, might suffer.

If you own your own business, you have to worry about a decline in sales. If you work for someone else, brace yourself for a cut in bonus or commission income - or, if things get really ugly, a layoff.

Over the past 60 years, the unemployment rate has jumped 0.23 percentage points a month during recessions. That might not sound like much, but it works out to an additional 350,000 workers on the street every four weeks. (You'll find advice here on the best ways to lower the odds that you could be one of them.)

The best hedge: cash
As a hedge - just in case the worst happens - the best strategy is to beef up your emergency fund. The standard advice is to keep at least three months' worth of living expenses socked away if both you and your spouse work and six months' worth if your household has only one earner.

But in a recession, a year's worth can make more sense, especially if you're near retirement or find yourself having nightmares about starring in The Grapes of Wrath. If you have no cash or barely any on hand, it even makes sense to sell stocks. It's never a good time to have no savings, and that's especially the case in a downturn.

Recognize, though, that this strategy carries costs. Money you've purposely sidelined won't be in the market should it rebound quickly. If like a lot of people you have some ready cash but not enough to tide you over for an extended period, you can avoid dumping stocks. Instead, put off major purchases, cut consumption and, if necessary, redirect money you're regularly investing in stocks into a savings account.

Where should the money go? Forget CDs: You need to be able to withdraw the money quickly without penalty in an emergency. A money-market account or fund will do. So will the savings account, which offers FDIC insurance and a yield of 3.5% (as of March 25) that competes with the best money fund

Risk #3: a dollar collapse
all it took was 87¢. If you've taken a trip to Europe lately, you know exactly what a weak dollar means for your travel budget. But how else does the ailing buck affect your life?

For starters, you'll pay more for imported goods from most other countries. Fuel costs will also go up because oil is priced in dollars and foreign buyers are bidding it up with their stronger currencies. True, a weak dollar does goose exports by making U.S. products cheaper. But overall it hurts economic growth at home, which in turn jeopardizes your financial well-being.

The wrong way to hedge the dollar is to trade currencies or buy individual foreign bonds. For an individual investor, guessing which way currencies will move in the short run or which country's money will outperform ours is as difficult (and senseless) as trying to amass retirement money at the roulette table.

Instead, the best way to hedge against a possible further decline in the dollar is to buy diversified mutual funds that invest overseas.

The best hedge: foreign stock and bond funds
Full disclosure: These funds have soared over the past five years, and it's hard to imagine that they can continue to outperform in perpetuity.

Yet the fact of the matter is, most individual investors still have too little of their money in overseas equities. The non-dollar-denominated stocks and bonds that these funds hold will give you wide exposure to currencies and economies that may be on a stronger track than ours.

If so, you'll stand to make money both on the currency exchange and on the strength in the underlying investment. Conversely, if the dollar strengthens against the currencies represented in your fund's portfolio, you could take a loss even if the underlying stocks hold up fine.

How much money to put into overseas securities? Experts say a reasonable approach is to keep at least 20% of your stockholdings in a broad-based foreign-equity mutual fund and 20% of your bondholdings in an international bond portfolio. (If you don't have at least that much in such funds already, put the money in gradually over several months so you don't wind up investing it all on a bad day.)

That 20% will give you enough international exposure to help counter the dollar's weakness, but it won't be so great that you or your portfolio will be devastated if the performance pendulum swings back to the dollar and U.S. stocks.

For the equity fund, consider the low-cost Vanguard Total International Stock Index (VGTSX), which has returned 6.7% annually over the past decade. For the bond fund, T. Rowe Price International Bond (RPIBX) is a good choice in part because it usually doesn't use currency maneuvers to hedge exchange-rate gains and losses as some other bond funds do. You need those exchange-rate fluctuations when your goal is to hedge the dollar.

Risk #4: the credit crunch

After making all those colossally dumb loans, financial institutions are now punishing you for their sins. According to a Federal Reserve survey in January, the percentage of senior loan officers raising standards on traditional mortgages jumped to 53%, up from 41% three months earlier. This marks the biggest shift to caution in at least 17 years.

But it's not just mortgages. It's now harder for you - even if you have good credit - to obtain other types of consumer loans, like an auto loan or a credit card. The news is even worse if you've got a less-than-perfect credit history. There seems to be no end in sight.

As Fed chairman Ben Bernanke told a Senate committee in February, "More-expensive and less available credit seems likely to continue to be a source of restraint on economic growth." Translation: Lenders who would have poured cash all over you a year or two ago will now be focusing on all the reasons they shouldn't. Thanks, guys.

So if you need financing soon - whether for a car or a home - borrow now, before lenders slam the door even tighter and raise rates to boot. True, the Fed cut the benchmark rate on overnight bank loans by two percentage points from January to March, to 2.25%.

But experts polled by still predict that mortgage rates will rise. The National Association of Home Builders forecasts that average 30-year mortgage rates will climb from 5.9% this year to 6.3% by year-end 2009.

Another reason to make haste: the possibility of recession and job loss. "If you're not employed, you're done," says Chicago-area financial planner Ed Gjertsen II. "You're not going to be able to get credit." So if you've been thinking about refinancing, don't wait.

The best hedge: a HELOC
Also consider a home-equity line of credit now. Yes, banks have gotten antsy about HELOCs that they've extended in the past. But if you've got sufficient equity in your home and a decent credit score, a HELOC can be a safety net that you can set up now - and you won't have to have oodles of cash on hand.

There's huge variation in pricing of HELOCs around the country, says Keith Gumbinger of HSH Associates, but the best deals tend to come from credit unions and smaller lenders. To find the lowest rates in your market, visit or click on the widget at the right on page one.

A recent search of the site found that in St. Louis, Heartland Bank offered an interest rate of prime minus half a point (translating into 5.5%) with no up-front or annual fees. Find a deal like that in your area and you'll be able to sleep just a little bit easier tonight.

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