Time to hedge your bets
BY TERRY SAVAGE Aug 30, 2010
Will all this economic uncertainty land in the red of inflationary boom or the black of deflation and depression?
Updated: May 3, 2013 12:14PM
In the roulette wheel of the economy, 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?
Eventually, the wheel will stop and some will collect a fortune on their bet, while others watch their chips get scooped away.
Good thing that dealing with your personal finances and the economy doesn't have to be a red or black all-in bet. You can and should hedge your bet -- especially if your goal is long-term growth and preservation of capital. Hedging means you won't come out with a big stack of chips, but you also won't risk losing the house.
Inflation or deflation?
History tells us that economies move in cycles. And the history of the U.S. 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 toward growth.
The real problem comes when your time horizon is shorter -- because you're nearing retirement, when you will have to use the cash, or because it's designated for a purpose with a short-term horizon, such as college for your children. Or perhaps it's your own emotions that won't let you take a longer perspective.
That's when you need to hedge your bets. But in order to walk a middle path, you need to understand the impact of inflation and deflation on your finances.
We think of inflation as "rising prices" because that's how inflation becomes apparent to all of us. But inflation is basically the central bank creation of too much money and credit. More "money" pushes prices higher. People want to trade money (cash or bank deposits) for something of greater value -- whether precious metals or commodities or real estate.
Just think of inflation as a giant Monopoly game, where the banker decides to get things moving by giving everyone some more paper money, even though they didn't earn it. In real life, that money pushes up the price of Boardwalk and Park Place, simply because there is more money in circulation.
Once people recognize that money-creation is happening, they demand higher interest rates to compensate for the loss of future buying power. If you are deeply in debt -- like the United States -- or have a floating-rate mortgage or credit card debt, those higher rates will add to your costs.
If you think inflation is coming, you'd want to buy things that historically "beat" inflation, like stocks or gold. And you wouldn't want to lock your money up now in five- or 10-year bonds even though they are currently paying a higher rate of interest. If inflation returns, bringing with it higher interest rates, you'd be stuck with those long-term, low-yielding bonds or CDs.
Deflation is the opposite side of the coin -- falling prices. In a deflationary period, people are so scared about the future that they hoard cash, even though prices are falling and making assets more attractive. Eventually, prices of things like homes, cars and computers will become so low that bargain hunters jump in. In the meantime, as money waits on the sidelines, the economy slows because no one is buying. And businesses cut jobs because there is no demand.
But because deflation is also a psychological problem, it can hang on longer than you might expect. People who fear for their jobs don't buy houses. And the longer they delay, the worse conditions get. It's a sort of self-fulfilling prophecy. Desperate sellers cut prices, and potential buyers are paralyzed fearing further price declines -- which then happen.
In deflation, cash is king -- if you can bring yourself to pull the trigger and buy the bargains. But debt becomes ever more destructive, as incomes shrink and people default on their loans. Even banks loaded with cash, courtesy of the Fed, are worried that existing borrowers will default. So they refrain from making loans, further slowing the economy.
In the middle
No one can tell you which extreme will happen -- or if we will muddle along somewhere in the middle. That's why you're not "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 10-year government bonds yielding only 2.5 percent.
The toughest place to be is in the middle -- sitting with cash. You get no immediate gratification. But you do get to sleep at night.
Cash is the toughest position to hold these days. Money market funds pay less than a quarter of 1 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.
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. And that's The Savage Truth.
Terry Savage is a registered investment adviser. Post questions on Terry's blog, terry savage.com, and at suntimes .com/savage.