December 19, 2001

Almost every time that the Federal Reserve cuts interest rate targets, I receive e-mails inquiring why falling interest rates are good for the economy. Almost always, these inquiries are made by retirees who are depending upon income from fixed debt instruments of limited duration, such as bank certificates of deposit.

Unfortunately, these retirees are suffering from the same problem that the technology chasing investors faced a year ago. They are not diversified enough.

I realize that retirees cannot afford to lose too much of their spending capacity. However, this is precisely what is happening by relying too much upon CDs.

If an 80 year old held high quality government bonds of long duration in equal measure with fixed interest CDs, the risk of default will be minimal. To be sure, long term government bonds change in price as interest rates fluctuate. However, the quarterly or semi-annual check will remain the same until the bond matures.

If interest rates fall, the value of the government bonds will rise. If necessary, some can be sold to partially compensate for the reduced interest rate payments that will occur as the CDs mature and are replaced by new instruments.

If interest rates rise, the market value of the bonds will fall, but the interest payments will remain unchanged. At the same time, the maturing CDs can be replaced by higher yielding CDs. Thus, interest income can actually rise. As the bonds approach maturity, they will rise in value until they will regain the principal at maturity.

Actually, I would always hold some equity positions. If they are not generating income, I can still sell them as needed to generate purchasing power. Why be more wedded to an interest check than to a check from the sale of some stocks? As long as these sales are done consistently, (remember, emotion is the enemy of sound investing), receiving purchasing power from sales is no less desirable than receiving purchasing power from interest payments.

Indeed, interest is taxed as ordinary income while the sale of stocks might be treated as a capital gain. Sound investment policy looks at total return (yield plus asset appreciation) not just yield.

Some financial studies actually argue that some relatively risky investment instruments along with sound core investment strategies may provide more returns for any acceptable risk than only using the core strategies.

About the only investments that have done well this year are the hedge funds. Managers of these funds use relatively risky instruments in a way that can significantly increase returns without seriously raising risks. They do so by buying and selling appreciable assets at the same time.

Both assets should have similar exposure to general economic risks, such as inflation or deflation, recession or expansion. The hedge manager then is making a bet on relative performance.

For example, I believe some of the best hedge strategies in the next twelve months concern interest rate maturities and currencies. For example, I believe the euro will improve in value because European policies will shift toward growth now that inflation has nearly vanished.

At the same time, the yen is harmed by intensifying deflation. Growth will remain anemic there until bold policies are pursued. If I am right, I would buy euros for future delivery and sell the yen short.

I also believe the long government bond in the U.S. is yielding much higher returns relative to short term rates than can be sustained. Therefore, I would buy the long bond and sell shorter term government instruments.

By themselves, each of these hedges must be done by expert traders. However, their returns are independent of other market forces. If the hedges are right, a great deal of money can be earned. Venture capital investing also has a disconnect with normal market forces and might provide large returns over time.

By adding a little of these high risk but high return alternatives to a core investment strategy, higher returns for any acceptable risk can be achieved.

With diversification, all investors could do better over time than they have been achieving by chasing either the safest or the most in vogue


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