A quick update to my post of last week discussing Zopa rates rising because of the credit crisis. Rates have now come down – my main lending offer to A* customers is now out of the ‘Zone of Possible Agreement’ (ZOPA), which in English means people can get such better rates from other Zopa lenders that they’re unlikely to call on my money.

I would have to drop my rates down to around 8.25% to re-enter the ZOPA, which I’ve decided not to do for now. In these riskier times, I want some extra security from this sort of peer-to-peer lending, so I’m going to leave my money offered at that current rate and hope for another cut in supply in the weeks ahead.

Zopa sensibly pays you an okay interest rate on money sitting in your account, so you don’t have to rush. It’s a lot less than what I could get from actual Zopa borrowers, but this isn’t the time for hasty moves I feel.

So there you go. Gold has fallen, the stock market is up, and Zopa is possibly signaling the credit crisis is abating. It’s certainly proving an interesting new barometer to keep an eye on.

Apparently there’s still £30 up for grabs through Zopa’s affiliate scheme for new members, but do check if you decide to sign up, as the small print would seem to contradict this. If anyone from Zopa is reading, you might like to update those details?

So you’ve done your four financial crisis checks:

• Your savings are safe
• They’re earning more interest
• You’ve got a plan to pay off any debt
• Your mortgage is sorted for the foreseeable future.

Time to turn over and fall back to sleep?

Possibly. I’m serious! It’s often too late to Do Something once a financial crisis is underway. If you follow the daily advice of the financial TV channels and churn your portfolio, the only person who’ll get rich is your stockbroker.

It’s better to calmly consider where you’re at, financially, and where you’re going. It’s certain you’ll encounter several testing times during your investing lifetime, and a cool head could save you a fortune.

In this post I’ll look at four more ways to deal with a financial crisis:

• Don’t sell in a panic
• Consider buying when markets are down
• Earn more cash before the crisis spreads to the wider economy
• Be sure to have a solid plan you believe in so you’re not spooked next time

1. Check your portfolio… calmly

At times of financial crisis, stock markets fall

If you’ve investments in funds or shares, you’re likely well down:

• Most stocks are hit in a financial crisis, usually before any impact is apparent in the economy
• Often a specific sector hurts the most, as with the dotcom bust
• The only exceptions in this 2007/2008 crisis are investments related to commodities, and the markets of countries dominated by miners and other commodity producers
• Bear markets pull everything down, so don’t expect that out-performance to continue if we’re in a true bear market

Are these falls rational? Can a big supermarket retailer, a provider of networking technology, and a manufacturer of metal cans ALL really be worth 10/20/50% less than just a few months ago?

Of course not. They were either overvalued then, or they’re undervalued now. Remember, the markets are driven by sentiment – fear and greed:

• Company specific falls in bull markets indicate bad news about that company
• Across-the board falls in bear markets tell you little about the companies and everything about the market.

No crisis is all bad news, financially-speaking, since different asset types respond in different ways.

In this current credit crunch of 2007/2008:

• Gold has risen
• So have government bonds, such as US Treasuries and UK Gilts, due to their rock solid security
• Corporate bonds have wobbled on credit fears
• Interest rates on savings are up, even after central bank base rates have been cut
• House prices are falling

This varied performance is why we’re urged us to diversify our portfolios. One asset going up will ease the unpleasantness of something else going down, just like sugar in a child’s medicine.

What this means for our investments:

• Funds and index trackers are volatile when the stock market is unsettled
• Pensions linked to the stock market will be down
• Most investors’ current net worth will fall. If you’ve a big portfolio built up over many years, the numbers can seem frightening when compared to your salary
• Diversified investing can reduce the pain

Action plan

• Unless you’ve been silly (putting all your money into real estate or tech start-ups or some other overweight bet) the best plan may be to sit tight.
• Don’t sell just because the market falls. As Benjaman Graham said, just because a gloomy Mr Market has slouched up with a particular price on some particular day, that doesn’t mean you have to accept it. One day he’ll be generous again.
• If you sell whenever the market falls, you’ll destroy your long-term gains…
• … unless you sell before they fall further, of course. But very few investors can consistently time market drops, and in my experience those who can seem to have trouble buying back in.
• Few great investors are market timers. (For instance, Warren Buffet isn’t selling, and in fact he may be buying). Buying and holding over reasonable periods is a better strategy for nearly all of us.
• If after several good nights’ sleep you decide you really are too exposed to some particular market, consider slowly selling down your holdings. Do consider though how you’ll feel if markets bounce back after you’ve sold!
• With stock markets, it’s fairly easy to do reduce your exposure (which is exactly why you should only do so calmly). With some assets, such as property, you’ll need to plan your disposals more carefully.
• Read up on asset allocation so you’re better diversified against future downturns. One very simple rule of thumb is to subtract your age from 100: hold your age in various bonds and the rest in shares. Some advocate an even simpler 50/50 ‘lazy’ strategy.

2. Consider buying more shares while they’re cheap

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I’ve just been checking out my Zopa savings account, where I’ve noticed interest rates are going up. I only ever lend to A and A* borrowers (people with great or better than great credit records) and the rate Zopa is quoting me as competitive is much higher than usual.

In fact, in the A*, 24-month market, I seem to be in the zone with an interest rate of 10.5%, which Zopa estimates will give me 9.5% after bad debt.

That 9.5% is almost 50% more interest than on the best savings accounts available from banks at the moment.

I’m gob-smacked.

• Previously Zopa’s edge on normal savings accounts has been more 1-2% above the High Street banks.
• The Bank of England is cutting interest rates, so this is a chance to ‘lock in’ a higher rate.
• That 9.5% is close to my expected returns from the supposedly much riskier stock market.

So should peer-to-peer Zopa lenders be filling their boots?

A quick Zopa primer

I’ve been meaning for ages to write up my experiences with Zopa, but a quick primer will have to suffice for now.

Zopa is a peer-to-peer lending site that’s been going in the UK for about three years, and recently launched in the US, Japan and Italy. It’s completely legitimate in terms of its business (although some criticize its business model!) It’s been covered by both the BBC and the FT.

Set up by experienced bankers who created Egg in the UK, the best analogy is it’s sort of like an eBay for money. As a lender you offer loans to members, while other members borrow money. You get access to the same credit checking the big banks use (or don’t use), and there’s (theoretically) all manner of checks and balances built-in to enable you to see what kind of rate you’re getting.

The big difference between putting money into Zopa and a normal savings account is that you can lose your money with Zopa.

There are safeguards against this – you might choose to only lend, for example, £10 to each borrower, and bad debt is taken into account in the expected returns – but it’s still a crucial difference. On the other hand, I’ve not yet had a bad debt, and nor has a good friend who has been a lender with Zopa for over two years.

I still plan to write a long post about Zopa soon, as it’s really fascinating. If you want to know more before reading on, check out that BBC story on Zopa.

So, should I lend money like crazy at 9.5%?

Clearly, the credit crunch is having an effect on Zopa’s peer-to-peer lending market, either by:

• Increasing the number of Zopa borrowers, and so decreasing the pressure for lenders to compete via reducing rates.
• Reducing the number of lenders, and so reducing the range of offers for borrowers to choose from.
• Making lenders nervous, so we’re all raising our rates.

Plus I see a fourth, really unpleasant possibility:

• More lower-quality (or even dishonest) borrowers are coming to Zopa.

Which is it? I wish I knew. If I could be certain those A* borrowers wouldn’t default in droves in the next 24 months, I’d take a 9.5% return like a shot. Certainly, if a big High Street bank was offering that interest rate, I’d sell down some of my shares to take that as a guaranteed return.

But Zopa lending is not guaranteed, and that’s a very big but indeed.

I’d say the likeliest cause of the rate spike is a combination of all of the factors I mentioned above. Rising rates in a system like Zopa make sense even if rates are falling elsewhere, because lenders like me always have the opportunity to just stick our money in a bank account instead if we’re unsettled, and will demand more return for taking the risk. And if Wall Street and the City is nervous about lending money because of rising bad debts, we should be, too.

On the other hand, my A* borrowers are (theoretically) the creme de la creme of customers. You can lend to sub-prime borrowers at higher rates on Zopa, but I don’t. So the risk of a mass default for me should be small.

The biggest issue for me is Zopa has not yet been tested in anger. We haven’t yet seen how individual borrowers will behave in a peer-to-peer system if money really becomes tight. With some economists predicting a 1980s-style recession in every way except the shoulder pads, that’s a very real risk.

On balance, I’m going to increase my lending a little, but not go crazy. I originally explored Zopa as an experiment, and it’d be terrible to discover that I’m the unfortunate guinea pig should the experiment turn sour.

Update: I’ve written a significant update of my positive experience with Zopa as of January 2009. You might also read this article from the FT.