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August, 2002


With the markets so volatile lately, often on the downside, money market rates perhaps the lowest they have ever been or close to it, and certain threats to most bond returns at least dimly on the horizon, what is an investor who wants relatively low-risk growth potential to do?

Here are just a few ideas for the reader's consideration. First, be sure you are allocated enough to allow you to sleep well at night but not so much that the assets will essentially cancel each other out or stifle the potential for good returns.

For instance, if you have a perfect balance of real estate, a commodity index fund, money market accounts, foreign and domestic bond assets (each of short-, medium-, and long-term maturity), small-, medium-, and large-cap domestic and foreign equity growth assets, small-, medium-, and large-cap domestic and foreign value assets, developing markets bonds and equities, collectibles, and personal property, you may find you have so many and well balanced eggs in your investment basket that the resulting portfolio just sits there, nicely unresponsive to the slings and arrows of outrageous misfortune, but also incapable of ever profitably taking flight.

A traditional mix that has worked for many emphasizes both growth and income but does not go overboard in either direction. Certainly one can have illiquid real investments, such as one's home, some precious metals investments, or collectibles, if one feels so inclined. Folks who have strong stomachs might even invest in rental properties. But do not mix such assets in with your liquid holdings when making portfolio decisions. Real assets or collectibles are at best a business or a marginal hedge against losses in the other investments. For most, though, they are more like a hobby. Dabble in them only if you enjoy it. They might even turn out to be profitable in the long run, but do not rely on them for growth or income.

Portfolio management decisions are usually appropriate for one's liquid holdings. A traditional mix can serve the average investor well: 5-10% of such assets in liquid reserves, such as money market accounts or Certificates of Deposit; 30% in a blend of bond assets; and 60-65% in individual common stocks and/or in stock mutual funds.

Historical returns are no guarantee for the future, but may give some idea how things might turn out over the long-term. On average, the annual returns for liquid reserves such as money market funds have been about 5%, while those for intermediate bonds were about 6%, and those for equities were about 10.5%, if one includes their dividends. Thus, if one puts together a portfolio that focuses, on average, on about 65% in relatively higher yielding stocks and mixes them in with 5% in the better yielding liquid reserves, and about 30% in a good, low-cost bond index mutual fund, such as Vanguard Total Bond Index Fund, and if the returns match those obtainable previously, a long-term, compound, annual total return of about 8% is possible (after "frictional costs"), with relatively little overall volatility, particularly if one rebalances each year or after equity swings of 10% or more.

But the current situation is somewhat unusual in several respects. To begin with, money market funds are now yielding not 5% but about 1.5%. Then, the federal reserve cannot lower interest rates much more. The fed. funds rate is already less than 2%, or about the lowest it has been in forty or more years.

The average (intermediate) domestic bond yield is only about 4% after expenses. But the total return on most bonds is determined not only by their coupons, dividends, or yields but also by their price, which, in turn, responds to factors like inflation and the direction of interest rates. Some bonds will rise or fall 12% for each 1% the interest rates fall or rise, respectively. Zero coupon bonds and some high-yield or junk bonds rise and fall with much more volatility. Some long-term zero coupon bonds could fall 25% or more in response to a rise in interest rates of 1%.

Since the fed. funds rate cannot go much further down, it seems reasonable that at some point in the foreseeable business cycle they will need to begin to rise again, with the predictably negative effects on bond returns.

At the same time, also looming dimly on the horizon are some signs that inflation may be returning in the next few years. Perhaps the major indication of this is that, since September 11, 2001, all of the hard-fought fiscal responsibility that had been achieved in the 1990s has been discarded in favor of multi-billion dollar spending sprees for a war on terrorism, homeland security, aid to farmers, aid to airlines, and a host of other pet projects to keep the voters happy with what the incumbents are doing, so they can be reelected. At the same time that spending has mushroomed, taxes have fallen. Therefore we now again have projections of large federal deficits instead of the surpluses that were so touted just a couple years ago.

Unfortunately, to pay for debt, whether at the federal, state, or local level (and state and local governments are, if anything, having even larger burdens now), more money must be printed, which is inflationary and which also adversely affects the return of bonds.

In this overall setting, it may be appropriate to:

1. Use short-term bonds in lieu of some of the money market account funds for a little bit higher yield in ones liquid reserves than with money market funds or Certificates of Deposit alone;

2. Lower the overall portfolio percentage of investments in bond assets, for instance to 25% instead of 30% of the liquid holdings;

3. As recommended in "Grant's Interest Rate Observer" one could do a lot worse than to invest a significant amount of one's bond holdings in TIPS, the very low risk United States Treasury inflation protected securities, either directly or through a low cost mutual fund (as through Vanguard);

4. Regain some of the portfolio yield no longer provided by money market funds or bonds by investing in high yielding but lower than average risk REITs (real estate investment trusts), such as Equity Office Properties (EOP), at $26.95, currently yielding about 7.40%, and New Plan Excel Realty (NXL), at $19.34, currently yielding about 8.50%, or in high quality preferred stocks, for instance Abbey National Sr 'A' ADS (ANB/PRA), at $25.85, currently yielding about 8.75%;

5. Further offset the lowered proportion of bond assets by focusing at least 5% of one's liquid assets in undervalued stocks with significant dividends, such as Alliance Capital Management (AC), at $33.40, currently yielding about 6.9%, and International Aluminum (IAL), which, at its recent price of $18.35, has a yield of about 6.5%, low debt, and a price to book value of just 0.65.

The suggested portfolio percentages may still provide a relatively generous overall yield of about 3% while also offering plenty of opportunity for price appreciation and in the context of lower than average risk.


Larry is not a professional. Don't take him seriously!

Actually, the investment article provided here is for general information only and should not be considered as professional advice, a solicitation to buy or sell any security, or the Word of God. Investors are encouraged to do their own research while considering their personal goals and circumstances, or consult their own professional financial advisors, before making investment decisions. Neither Larry nor LARVALBUG will be liable for any losses sustained by any visitor to this site.

(Disclosure statement: Larry and Val have holdings in some of the suggested assets but do not "make a market" in any of them and do not derive any direct benefit from recommending them, except perhaps for a bit of smug self-satisfaction.)

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