Add this to the list of reasons why “buy and hold index funds” is a relatively good investment strategy: It’s not a Ponzi scheme.

A bit of explanation: In a Ponzi scheme, a shady operator takes in money, claiming to invest it. It pays off handsomely at first, it seems — but the payoff is illusory because it comes from scamming in new investors. Their money pays off the first investors, but now the Ponzi operator has to go find still more investors to keep up the appearance of a good return.

A Ponzi scheme was limited to scamming small-time ill-informed investors, or so we thought until Bernard Madoff was caught in a $50 billion Ponzi scheme that took in wealthy upper-crust clients. And that brings me to the point. If you buy and hold reputable index funds you can expect to make money over the long haul. You will have some bad years, like 2008. But you’ll never lose it all to a scam.

For the average investor, it’s hard to beat “buy and hold” over the long term, even though there will be times — such as now — that other strategies will look attractive. One such strategy is the “black swan” strategy popularized by Nassim Nicholas Taleb. The strategy is named in honor of the once-received wisdom that black swans were impossible — until black swans were discovered in Australia.

Taleb’s strategy essentially involves betting that rare events (financial “black swans”) will eventually happen, and being positioned to take advantage of those rare events. This year, that strategy has worked out well, producing returns of more than 50 percent.

So, should we all jump on the black swan bandwagon? Here’s why we shouldn’t:
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Those who make big sudden changes in their portfolios almost always regret it. Example: If you sold right after the 1987 crash, you lost 24 percent. If you held on two years, until September 1989, you got it all back. So take a deep breath and think hard before doing anything.

In my book, I recommend not investing in the stock market until you have your financial house in order and are willing to let the money stay in the market. And once you’ve reached that point, you buy and hold.

Recent events again confirm the wisdom of this position. Those who tried to flee the market meltdown of fall 2008 were, in general, too late. The panicked news coverage followed the worst declines. So an investor who read the coverage and then pulled out was “selling low.” That same investor, who won’t get back into the market until things look more optimistic, will at that time be “buying high.”

Do you see the pattern? “Buy high, sell low.” That’s a sure route to ruin. When all this turmoil clears, count on it: Those who do the best will be those who followed the sound advice of “buy and hold.”

And, one more thing: Suppose someone sold after the first ten percent of a market decline, and then bragged about having missed the worst of the decline after the market went down another ten or 20 percent. That bragging would turn to regret over longer periods of time, if history is any guide.

Wall Street is going crazy, but how can you make sense of it all? Here is plainmoney.com’s simplified guide in ten easy steps:

1. It starts with the old-fashioned savings and loan association, like the Bailey Building & Loan in the classic movie It’s a Wonderful Life. That savings and loan association would accept deposits from people, loan them out on mortgages, and all was well. (Stay with me; this is going to be easier than you think.)

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Is the current meltdown a failure of deregulation and private markets? Consider these important facts and then make up your mind:

• Fannie Mae and Freddie Mac were the key players.
• Fannie and Freddie are GSE’s — that is, government-sponsored enterprises. That means they were, uh, sponsored by the government. Not only that, they were chartered and regulated by the government.
• Fannie and Freddie took huge risks with an implicit guarantee that the taxpayers would pick up the tab if they failed. That implicit guarantee has now become explicit.

There’s an easy narrative that says “We didn’t regulate.” In the case of Fannie and Freddie, that’s simply wrong.

Maybe in the future we will regulate players like Freddie and Fannie better than we did.  I hope so. Make no mistake about it though: Fannie and Freddie were government chartered and government regulated. They were not private and they were not deregulated. (Plenty of people took stupid risks with the securities that Fannie and Freddie enabled, but that’s another story.)

One more important note: This is not really a partisan point. Here, for example, is a columnist who favors Sen. Obama for president and recognizes that deregulation is not the source of the current financial troubles. And the Washington Post, hardly a bastion of conservatism, has a thoughtful piece showing how the 2008 meltdown was a failure of distorted markets, not free markets.

The Wall Street Journal columnist Thomas Frank has come up with something he calls “conservative economic theory,” apparently placing the term in the mouth of a source on the subprime mortgage fiasco.

Like many people outside the field he assumes there’s a conservative economic theory and a liberal economic theory — overlooking the large analytical core shared by all economists. What does that core say about the role of mortgage originators in the subprime affair?

Simply this: that self-interested private firms disregard the costs they place on others. (See “externalities.”)

Therefore, if you want firms to be careful about costs, you make sure they pay the relevant costs. In the subprime mortgage affair, mortgage originators faced simple incentives to write as many mortgages as possible, short of outright fraud. They received origination fees for doing that while being relieved of liability if the owners later defaulted. Naturally, the law is complicated, but mortgage originators who simply reflected the overall market’s bad judgment — as opposed to committing fraud or misrepresentation — aren’t in much trouble.

Put yourself in the position of a mortgage officer. The housing market is hot and a ready market exists to buy up the loans you write. Are you going to inquire deeply into whether the borrower will pay it back? I didn’t think so.

It’s not a failure of economic theory, “conservative” or “liberal” or otherwise, when people respond rationally to perverse incentives. The task for reform is simple in concept: correct the incentives (as opposed to lamenting greed or making broad pronouncements about non-existent schools of thought).

How do Wall Street’s troubles affect ordinary people? Here are some possible outcomes:

1. A rescue plan is passed and is effective. Then we get a minor increase in overall unemployment, two quarters of economic recession, and we’re done. Maximum unemployment is about 7 percent or so.

2. A rescue plan is passed and doesn’t work. Then we get an extended recession, possibly taking years to recover, with unemployment maxing out at about 10 percent.

3. No plan is passed. Here we get into uncertain territory. It all depends on how adaptable our economy is in getting savings converted through to make funds available for economic activity — something our system has been very good at, but that now seems shut down by the events of September 2008.

How bad is a recession in general? It’s terrible for those who lose their jobs, but in the U.S. it doesn’t mean people starve in the streets. Remember, even if unemployment hits 10 percent, 90 percent of the labor force is still working. As for making drastic changes in plans because a “recession is coming,” that’s a losing game. Example: Should someone drop out of college to save money because “a recession is coming”? Answer: No. The average recession lasts about 11 months. It’ll be over by the time you graduate.

Examples could go on and on, but you get the idea. Anything that’s a smart idea now — such as working hard and saving — will be an especially good idea is there’s a recession. Dumb ideas — such as buying a fast car you can’t afford — become even dumber if there’s a recession.

I have gotten this question a lot. Here’s an answer, step by step:

1. Nobody knows what will happen, including me. So be skeptical about anyone making predictions, including me.
2. If there really is going to be a collapse of financial institutions in the absence of government intervention, then we will have a long period of economic distress. It would have all the usual hallmarks of tough economic times: stagnant income growth and high unemployment. People would not starve in the streets, however, and it would not be another Great Depression.
3. But there’s reason for skepticism about collapse. One alleged example of collapse was that McDonald’s was having trouble getting working capital. That proved to be overblown, and beyond that: Do you really think that a business model as sound as McDonald’s couldn’t somehow get funded in its day-to-day operations, even with ready investors holding trillions of dollars of cash and looking for a return? My own opinion is that awkward makeshift institutions would begin to fill in the gaps and McDonald’s would find a way to run. It wouldn’t be as good as our current system but I think we would muddle through.
4. Politically, both sides have been guilty of brinksmanship in the proposed bailout. The Democrats have been trying to get goodies for political allies in the bailout, while the House Republicans have been trying to put in some long-hoped-for tax changes. This is not the time for any of that.
5. So, my favored solution: Do a clean, technical bailout that allows the government to buy up distressed mortgage-backed assets and establish an orderly market for their disposal. If there are eventually profits from this, apply them to reducing the national debt.
6. And when all this is done, get the government out of the business of holding mortgage debt.
7. And for the future, try to draw a sharp line between assets the government will guarantee (such as bank deposits) and those it won’t (such as hedge fund holdings). Then try to structure things so that anyone who places a bet on non-guaranteed assets is on their own. Too often we have allowed people to take giant risks, reap the giant returns, and then put the losses on the taxpayers if the gamble goes bad.

In my book, I recommend not holding onto the stock of your own employer. Instead, the best strategy is “buy and hold index funds.” Those are diversified funds that have a little bit of each of wide variety of companies.

If you hold the stock of your employer, you’re taking a double chance. First, you’re taking the risk that a single stock will decline. But second, you’re taking the risk that when your company’s fortunes decline, you lose big in the stock market and lose from job-related effects.

Some employers will match your purchases of their stock. Fine. Find out the time limits and, as soon as you’re permitted, diversify out of your own employer’s stock.

There are many tales of woe from people at Enron, Merrill Lynch, Lehman Brothers and AIG that all made the same mistake — holding their own employer’s stock in large amounts. Don’t make the same mistake.