Why You Need to Hedge Your Bets

08/30/2010 11:03 am EST

Focus: MARKETS

Terry Savage

Author, The Savage Truth on Money

In the roulette wheel of the economy and the markets, it’s time to place your bets. Red or black? Will all this economic uncertainty land in the red of inflationary boom or the black of deflation and depression?

The wheel spins, the ball bounces, and players hold their breaths as they watch the dizzying turns of the wheel, and the ball bounces from one marker to another.

“Are you all in?,” the croupier asks, watching the piles of chips on the table as people press their bets. Eventually, the wheel will stop and some will collect a fortune, while others watch their chips scooped away.

And the house will always have the edge.

Good thing that figuring out the economy doesn’t have to be a red or black all-in bet. You can hedge, staying somewhere in the middle. And while you won’t come out with a big stack of chips, you also won’t risk losing your nest egg, either.

The headlines of the past week, forecasting the tilt toward deflation, with some using the capital letter Depression, reminded me that economists and market timers choose sides because that’s how reputations are made. But you’re not required to pick between red and black—especially if your goal is long-term growth and preservation of capital.

So, why move your chips at the last minute before the bouncing ball stops? Why be all in—or all out?

History tells us that economies move in cycles. And the history of the US tells us that those cycles trend ever-higher, although not without some low points. So, if you can ride out the cycle and have a longer-term perspective, the odds are on your side if you stick with a bias towards growth.

Remember, according to the market historians at Ibbotson Associates, there has never been a 20-year period where you would have lost money in a diversified portfolio of large-company US stocks with dividends reinvested—even adjusting for inflation.

The real problem comes when your time horizon is shorter—because you’re nearing retirement where you will have to use the cash, or because it’s designated for a specific purpose, such as college for your children. Or perhaps it’s your own emotions that won’t let you take a longer perspective.

That’s why you shouldn’t be “all-in” in either the stock market or bonds. You know that if we do slip into the “D” cycle, it won’t be good for stocks. But you also know that if inflation looms, you’d hate to have your money tied up in ten-year government bonds yielding only 2.5%.

Cash is the toughest position to hold these days. Money market funds pay less than a quarter of one percent. Seniors gripe that they planned to live on their interest, and now must dig into principal. Stock bulls point to much higher dividend yields, enticing risk-taking. And bond bulls tell you to get into fixed income now—before rates go to zero.

Annuity salespeople point to guaranteed returns, linked to stock market performance—without telling you how they’re hedging those promises. Everywhere there is temptation. And everywhere there is unforeseen risk.

Here’s the toughest advice of all: Sit this one out. You already have bets on this wheel—your home, your job, your retirement. Your goal should be to balance them all out—to hedge your bets. When you’re in the middle, sitting on cash, you get no immediate gratification—but you do get to sleep at night.

Sure, own some gold investments, which could benefit in any environment. Sure, be glad you bought a bond fund that shows gains, and stuck with your stock fund that eventually will move you ahead.  

But unless you define yourself as a speculator, it’s not your job to go all-in on red or black. Leave that decision to the pros—no matter how scary the headlines. You have more to lose than to gain.

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