Tuesday, July 31, 2007

Tuesday, July 10, 2007

Economics 101+

Here are a couple of interesting pieces on economics.

First, Economics in One Lesson explains capitalism and the typical mistakes a government will make when they intercede.

Next, Money as Debt (47 min) gives a somewhat grimmer (and perhaps more realistic) view of the state of the economic society.

I often wonder what the right kind of investments are if the doomsayers are to be believed - that the US economy and currency will collapse under the weight of its own debt. I got the following good advice from Wendy over at the Fool Message Boards on this subject.

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Because this is such an important question, I have been thinking about it carefully, rather than writing a "snap" response.

In all cases, your actions must follow your personal timeline (short/ long term) and personal risk tolerance.

Since you are new, to the METAR board, you may not be aware that I am one of the most risk-averse board members. Everything I write will be colored by my personal need to reduce risk. A risk-reducing attitude is quite different than a market-playing attitude (where maximizing return may outweigh risk considerations).

The nature of your question implies that you are already keenly aware of risk. You appear to be trying to reduce the risk of the danger of a falling dollar.

The question, "What is the danger to me of a falling dollar," requires careful thought. A falling dollar means "A falling dollar against one or more other currencies."

In the U.S., we purchase many goods and services that are produced locally. The cost of these won't be directly impacted by the relative value of the dollar to, say, the euro or the yen. Many of the household's largest expenses -- the cost of borrowed money (mortgage and credit payments), insurance, medical costs, food -- are not directly impacted by the relative value of U.S. currency.

The CPI-U (the rate of inflation, including food and energy) reflects the increased cost of living in the U.S. It is calculated by the government (Bureau of Labor Statistics).

The risk of a falling dollar impacts inflation by increasing the cost of imported goods, both manufactured goods, and raw materials that we compete for, on international markets (e.g. oil). Producers in (say) China or Saudi Arabia will demand higher dollar prices, to maintain their purchasing power, in the global economy.

Another risk of a falling dollar is that foreign lenders (who buy 40% of Treasury debt) may demand higher interest rates, to compensate them for the loss of their interest payments, which must be converted from dollars into their local currency.

When you consider investments that will reduce the risk of a falling dollar, you should consider the inherent risk of the investment itself. It won't help to "protect" yourself from the risk of a falling dollar, if you choose a risky investment that loses money.

Several of the investments that you mentioned are quite risky, since they attract speculators. For example, currencies are frequently manipulated by central banks and other large players. Commodities, such as oil and gold, are also subject to wide swings, due to manipulation.

You asked about hedge funds. These are highly risky, for two glaring reasons. First, the managers take 20% of the profits, right off the top. This means that the fund is forced to take high risks, in order to provide the investor with a greater yield than he could get by investing in a 0.2% expense Vanguard index fund. Hedge funds often use leverage, and speculate heavily.

Buying foreign stocks is risky, for the many reasons that any prospectus for a foreign stock mutual fund will list. It really is worth reading the prospectus! You ask about the specifics of different funds. Each will be different. It is your responsibility to read the fine print, and make a judgment call.

One risk that the prospectus doesn't mention is that it's almost impossible to calculate whether you are getting a good value on foreign stocks (based on fundamentals), or whether the prices are speculative.

This is my advice, which is designed to reduce risk. This advice will not maximize returns, but it will minimize losses and fluctuations.

1. CPI-U inflation risk can be mitigated by investing in individual Treasury Inflation Protected Securities (TIPS bonds). TIPS pay a fixed interest rate, and the principal is adjusted upward by the CPI-U inflation rate. This maintains the value of your dollar, based on its average U.S. purchasing power. This is the most direct way to address the impact of the falling dollar's impact on your household.

Today is the 10-year TIPS auction (twice-yearly). Get more details on the Bonds & Fixed Income board.

2. Dividend-yielding stocks of U.S. companies with significant exports help protect against a falling dollar. A falling dollar makes U.S. goods more competitive overseas, so exports will rise. Foreign sales will be converted into higher dollars, so the dollar profits will rise. Fundamentals of U.S. companies are much more transparent than foreign companies, and many pay decent dividends.

The safest way to invest in U.S. companies is to dollar cost average into a low-cost index fund (such as Vanguard's VTSMX). If you want to buy individual stocks, take a look at the BMW Board, which uses an excellent statistical analysis system, for determining when stocks are undervalued (plus, they are strong on fundamentals, which are important).

Stocks and bonds should be the backbone of your portfolio.

To jazz things up a little (add risk, but also add the potential for reward), you can add a small proportion of currencies, precious metals, foreign exposure, and commodities.

You can buy currency-denominated bonds at www.everbank.com. Remember that currencies are manipulated six ways from Sunday! This is riskier than they will tell you.

You can buy several different flavors of international funds at both Fidelity and Vanguard.

I have small amounts invested in Vanguard's Precious Metals Fund (VGPMX), Energy Fund (VGENX), and Developed Markets Index Fund (VDMIX) and also in U.S. Global Investors Global Resources fund (PSPFX), which sonnypage recommended. You could invest in the corresponding ETFs, and/or in GLD and SLV, the precious metals ETFs. One problem with owning precious metals outright is that they don't pay dividends.

The METAR Board hosts members across the spectrum of risk tolerance. I may sprinkle a little of sonnypage's advice into my portfolio, as "spice," but his concentration of assets is extremely risky. It will only work for him if his evaluation of future events is exactly right. I am, personally, too humble to believe that I'm always right, so I diversify.

Going back to your original topic:

Discussion of risk in future scenarios isn't "fearmongering." The best way for a small investor to avoid loss is to be avoid the potential danger. Each scenario has a profile of risk and opportunity, and a probability of occurrence. Personally, I allocate my resources to reduce my risk, given my evaluation of the probability of the scenario. This may mean that I bypass opportunities, by reducing my exposure to higher-risk investments.

I suggest that you write a list of your expected scenarios. Some will be benign. Others will have lurking dangers. Assign a probability to each. Assign the expected return, for each. Assign your tolerance to risk, for each. Allocate your assets based on your combination of risk and reward, given your time frame.

Do not risk any money that you will need in the near term. Always keep at least 3 to 6 months of living expenses, in liquid form (money markets and a short-term CD ladder), as an emergency fund. If funding your e-fund doesn't leave any investable capital, don't invest.


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I Barf'd Wine

Monday, July 9, 2007

Call me Ishmael

First post! What do I win?