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2008 was a historic year for fund investors. Until 2008, most bad markets still enjoyed a few rays of sunshine in the form of one or two categories that went up or perhaps fell only slightly. 2008 changed things. In 2008, essentially everything fell.

Having learned over the years that diversifying into various investment categories – international, small cap, natural resources, etc. – lowered downside risk, investors have been spreading their money around more than ever.

Top-selling investment books are often good indicators of what not to do with your money, as readers of Dow 36,000 can now attest. Before the 2008 debacle, authors penned best sellers on commodities, diversification, and portfolio building. Readers of such popular advice convinced themselves that this time the bear market wouldn’t bite.

But there was simply too much money pouring into too many areas for the markets not to collapse. After all, everybody couldn’t be right. The fund industry launched hundreds of new products – mostly ETFs – in an attempt to offer more diversification and targeting of portfolios than ever before. When was the last time we saw such a plethora of new fund launches? Right before the 2000-2002 crash. An arrival of new funds also heralded the arrival of two other bear markets – one in the 1970s and one that led up to 1929.

More Money = More Problems

Although the number of investing ideas climbs in overheated markets, the number of good ideas does not. This problem has grown over the past century because the world is richer following years of wealth creation. The trouble with this scenario? Greater wealth does not necessarily make for more quality investment opportunities.

The 2008 market crash destroyed more wealth than any before it (1929 the possible exception) because a large number of asset types fell sharply, including real estate, in which tens of trillions of dollars is stored globally.

The crash led to sharp selling of mutual funds – notably near the end of last year following the majority of the fall (hopefully). Some $230 billion dollars came out of stock mutual funds in 2008 – about 5% of assets - a huge chunk, historically speaking. More money left the market in the final months of ’08 than during the very bottom of the market in 2002.

Buckets of money have been poured into money market funds, in spite of recent troubles in that area (when a very large and famous money market fund "broke the buck" and actually began losing money for investors.) There's now more money in money market funds (around $4 trillion) than traditional stock funds (not including balanced funds).

Not only is this a remarkable statistic in and of itself, it also means it's very likely stock funds will become the place to be over the next few years.

Our optimism, as demonstrated by our increasing allocation to stocks in recent months, is tempered by the nagging fear that this might be the big one – the market and economic event so ugly it puts 50% or more of the money managers out of business.

Finance has grown too big, a point we noted a few years ago in our newsletter. Today's investors have grown weary of the roller coaster ride. If 2009 is as bad as 2008, we won’t need so many employed by the business of investing because there won’t be as many investors left.

As much as we’d like to see the overpaid investment bankers who created and sold now near-worthless mortgage securities forced to get a real job (good luck today…,) the probability of that happening is probably pretty low.

As for our own performance, while we're happy to have booked another S&P 500-beating year in all of our model portfolios, things could have been better.

Our portfolios' downward plunges ranged from 8-25% (compared to the S&P 500’s 37% hit.) Since early 2002, when we started our model portfolios, our total return is between 26% and 71%. The S&P 500 is down 10.75% for the same period.

Broadly speaking, our biggest mistakes were underweighting government bonds and cash (particularly in our more conservative portfolios) and a lack of good counter market funds in our more aggressive model portfolios.

We were also so excited to see investors finally bail out on stock funds that we moved into stocks and high-yield junk bonds a bit too early. We should have remembered from 2002 that you often have months to go from when the selling goes into overdrive before the rebound takes place. Plus, this time we're coming off a real estate bubble that makes the tech stock bubble look quaint by comparison.

Government bonds did very well in 2008. While we made money in bond indexes , we should have allocated a little differently, because government bonds were very unpopular. In fact, most pundits and experts recommended shorting government debt. The trick here is that government bonds are always fairly unpopular with fund investors. Wall Street doesn’t actively market them as ‘finished products’ since it's hard to rationalize an expert’s advice in picking, much less an expert's high fees and commissions. Why own a government bond fund with a 1% expense ratio anyway? Wall Street likes products that can handle high fees. That's one reason Bernie Madoff was so popular with intermediaries…

On the more aggressive side, we were disappointed by our funds that shorted stocks. Broadly speaking, there are no good funds that short stocks. There are a few acceptable ones (we’ve owned some). The inverse funds are suitable only for short-term trading, not longer-term strategies like shorting real estate, as we have for over a year now.

Call us old-fashioned, but when we shorted real estate in 2008 – the worst year for real estate-related investments on record – we expected to make money. The trouble is, these leveraged engineered short funds are designed to move in daily inverse to some benchmark index, not over long periods, which is what we want. If the index moves a certain way, you can actually lose money on a short fund, even if the index is down for the month, as was the case with a short emerging markets ETF we owned during one month last year.

Gripes aside, we have some short funds that were up around 300% and greatly reduced the downside from our long positions. We’re working to fine-tune this strategy – perhaps with more active trading – though if the market continues down, there may not be much more opportunity to short.

Here’s looking forward to 2009, and another year of our stock-heavy portfolios beating the S&P 500. Let’s see if we can make it 7 out of 8.