 If you've even casually followed the news over the past several months, you've probably heard about "subprime loans." But the issue can be confusing, and if you're like most people, you really just want a couple of questions answered: How might these subprime loans affect the economy? And will I need to adjust my investment strategy?
To begin with, let's define subprime loans. Generally speaking, a subprime loan is a mortgage made to a borrower who might not otherwise qualify for a loan. Subprime lenders typically charged these borrowers higher interest rates, but some subprimes were adjustable rate mortgages (ARMs), which meant they carried a lower rate for the first few years of the loan. Many subprime borrowers took out ARMs, hoping their credit would improve enough for them to qualify for a better rate before the mortgage rate was adjusted upward. When this didn't happen, they were hit with higher payments and many faced foreclosure. Because many of these mortgages had been resold and then packaged into other financial vehicles, the bad loans hurt these investments.
Ultimately, the subprime loan problem
might jolt at least two sectors of the financial markets: housing
and financial services. So, housing-related investments, such as
real estate companies, and financial services firms, such as mortgage
lenders, might experience some rough roads. Also, the subprime situation
could lead to a potential slowdown in overall consumer spending.
Why? Because if lending standards tighten, people may find it more
difficult to tap home equity loans and lines of credit. And if consumer
spending does slow, it could affect corporate profits, a key driver
of stock prices.
As an individual investor, what
moves, if any, should you make to prepare yourself for any potential
subprime "aftershocks"?
To begin with, don't get so caught
up in a possible subprime-fueled downturn that you overlook the
many positive factors about the current investment outlook. Although
the real estate industry is slumping, the rest of the economy remains
relatively strong. Furthermore, inflation and interest rates remain
low and stable, and corporate profits still exceed expectations.
And no matter what happens in the
investment world, you can hardly go wrong by following these tried-and-true
techniques:
- Look for quality. Quality investments, such as the stocks
of strong, established companies, historically tend to fall
less than other investments in down markets, and they have frequently
lead the way in the recoveries that follow. Past performance
is not an indication of future results.
- Choose an appropriate mix of investments. Build a portfolio
containing a variety of investments that are suitable for your
goals, risk tolerance and time horizon. While diversification,
by itself, can't guarantee a profit or protect against a loss
in declining markets, it can help reduce the effects of market
volatility.
- Hold investments for the long term. By following a "buy-and-hold"
investment strategy, you can reduce your commission costs and
avoid some of the other problems that can result from frequent
buying and selling. Once you buy an investment, consider holding
it until either your needs change or the investment itself has
evolved in an unexpected way.
By looking beyond the possible
turmoil and sticking with good investment habits, you may well escape
some of the problems caused by the subprime fallout - while you
stay on track toward your long-term investment goals.
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