Hold ’em, fold ’em or walk away?

Published 11:08 am Thursday, February 28, 2008

In the words of Kenny Rogers’ song “The Gambler,” “You got to know when to hold ’em, know when to fold ’em, know when to walk away, and know when to run” (yeah, I know I’m dating myself). The problem is the stock market isn’t gambling, it’s investing.

By the time you read this, I don’t know if the worst will be behind us or if the market will still be volatile. If I had to bet on it, I’d bet that the markets will still be volatile, searching for the next bull market. We do believe that there are risks worth taking in the market. However, the market does not reward you for every risk taken.

The risk of being in the market instead of cash is a risk you can diversify up to a point; the remaining risk is called the “risk premium” and is where you would expect the return to come from over the long term. Being concentrated in a few companies or a sector is generally seen as a risk that can be diversified away by owning the entire “market.” While it is possible to hit the homerun by being concentrated, it is also possible to strike out. Just recap the financial sector for the second half of 2007 and into 2008.

Late last year, John Bogle, the 1974 founder of the Vanguard Funds, was a guest panelist on CNBC. During the interview, he was asked what changes he was making to his portfolio in light of the market volatility. The panelists waited with excitement, ready to hear the wisdom of the man who, according to Wikipedia, grew Vanguard to the second largest mutual-fund company in the world under his leadership. His unexciting answer was, “I haven’t changed my portfolio in 15 years.”

It wasn’t very satisfying to the group, so they persisted. He went on to say that, at the end of the day, you have to decide if you are an investor or a speculator. He said, “I’m an investor.”

The investor vs. speculator decision is crucial. Speculators can be swayed by the minute-to-minute news of the day. Some enjoy this, but I think the ability to detach yourself emotionally is very important; otherwise, you’ll likely need some kind of professional counseling. Investors have the long term in mind and often can stay the course when the markets are choppy.

So let’s say that you’ve decided to categorize yourself as an investor. Assuming you have a good handle on your investment temperament and time frame, you also need to know the purpose of your investment activity. More on that in a minute.

When asking about time frame, it is usually phrased in the terms of “investment time horizon.” Often, a mistake is made about this fundamental question in that many clients think their time horizon ends when they retire or some other event occurs. We ask this question a little differently. We ask, “How long will you be invested before needing to make substantial withdrawals from the portfolio?” (Substantial is defined as greater than 5 percent annually.) If your goal is to limit your withdrawals to 5 percent annually, then it is likely you will need to be invested your entire life.

There can be a substantial difference between saying your time horizon is 10 years and living through 10 years of a choppy market. A good adviser will be sensitive to what the intellectual side of our brain says vs. what the investor behavior or the emotional side is telling us.

The purpose of your investment needs to be considered. It also is important to determine what stage of life you are in. Volatility, when you are young and investing regularly for retirement, such as in your 401(k), provides opportunity to go back in time and get shares at last year’s cost. Investing regular dollar amounts at regular intervals, regardless of price, is called “dollar cost averaging” and it can help manage risk. Therefore, when the market goes down in this scenario, you should be cheering because you are getting more of the cheaper shares (although your friends might give you funny looks).

On the other hand, if you are drawing from your portfolio for income, this volatility can be unnerving. A strategy to consider here is to have a year’s worth of income set aside in cash, like a savings account. The cash won’t fluctuate and you can have more patience during rough patches. At about halfway through the period, I start looking for opportunities to replenish the cash account. Your adviser can help you with this or some other strategy. As of this writing, my family and I are adding to our investment positions. We are investors. You decide what is best for you with your adviser.

Dale Terwedo, certified as a CFP, ChFC and CLU, is principal of Terwedo Financial Services LLC, an independent financial services firm in Edmonds. For more information, send e-mail to retire@tfsadvisors.com or call 425-776-0446.

The views expressed are not necessarily the opinion of FSC Securities Corp. and should not be construed as an offer to buy or sell any securities mentioned herein. Investing is subject to risks, including loss of principal invested. No strategy can assure a profit or protect against loss.