If you've even casually followed the news over the past several months, you've probably heard about "subprime loans."
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?
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.
Real estate investments
Housing-related investments, such as real estate companies, and financial services firms, such as mortgage lenders, might experience some rough roads.
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.
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.
Buy and hold
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.