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Wednesday, February 2, 2011

Best Strategy for Fixed Income Savings

In response to my post this past Saturday titled "Why Natural Resource assets is better investment than US Bonds", my friend John Chinnock has emailed me a response. In the email discussion and Instant messaging, John clarified something I was not fully understanding in his strategy. The key to his approach is to purchase highest yield bank CD's with reasonable penalties when the CD is broken. The Bank CD's must be 100% backed by the US government. John Original post is located here on this topic.

In combining my view of 25% resource based investments, with 50% (or more) in John's approach, which I agree is the best strategy for fixed income considering all risks. The remaining 25% is a discretionary investment, perhaps all CD's, more resources or other investments. However I am still in disagreement with John of 100% in CD's. I'll reserve a tit-for-tat post later. For now, here is John's response. Thanks to John for re-hashing his point on CD's.

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I wanted to take the time to write an alternative viewpoint to Murf's post on resource investing. Most of what I think has already been covered in my other guest posts on Murf's site, however, I will try to recap and elaborate. Again, I hope readers appreciate Murf always taking the time to work on his blog, as he really is a very busy guy. His writings here have helped friends and family members preserve their life savings in tricky investing times.

Murf and I basically do agree on the big picture. In the long run, commodities will likely go much higher. His reasoning is clear. Demand for better food and resources will multiply exponentially as more and more of the world's population rises above the poverty level. In time, largely due to the internet and better worldwide communication, the poorest countries will slowly start to accumulate money, and in turn, they will want better food and better resources. An example of this has already been occurring in India, where so many U.S. companies are turning to for job outsourcing. This is just the first step though, as after India, there will be cheap labor coming from many other countries, likely starting in southeast Asia, and then spreading to Africa. Note that this powerful phenomenon known as global wage arbitrage will also work to keep American salaries down for many years. A company has very little reason to hire someone here for a $50K per year salary, when the same job can be outsourced for $5K per year or less. This global change will likely persist for several decades at the very minimum, and will be an extremely powerful deflationary force, especially in the U.S.

The question I ask Murf is, will resource investing strongly outperform FDIC guaranteed CD's over the next 5 years? Readers can access my previous article on why CD's are far better than government bonds. There is something to be said for 4% interest coming in every year, absolutely guaranteed. While there is a chance of loss of purchasing power vs. inflation, there is no chance of loss of principal invested in absolute terms. The same cannot be said at all for resource investing. While unlikely, you could invest in oil, gold, and food, and watch all three be cut in half over the next few years. If you lose half of your life savings, the least of your worries will be maintaining purchasing power vs. inflation! The secret to growing and maintaining wealth is avoiding large blowups. Catastrophic losses are nearly impossible to recover from in investing, especially without then taking further enormous risk in an attempt to recover. And even if resources do outperform CDs, 3-4% consistently every year does add up nicely, especially with dividend reinvestment. Often the high-flying investments strongly outperform CD's for a while, but after one vicious downturn, one would have been better in the slow and steady investment. This also doesn't factor in the ability to have total peace of mind. If the Fed ever decides to end its money printing scheme in recognition of its failure, commodity prices could fall 20% or more in a matter of days. Imagine suffering through that with your life savings invested in resources! These worries are non-existent with CDs.

Another strong argument in favor of CDs relies on buying CDs with small penalties for early withdrawal. If Murf's inflationary scenario does play out, interest rates will spike, or at least slowly trend higher. Unlike with government bonds, with CDs, if rates move far higher, you can simply break your CD, pay the small penalty, and reinvest at a higher rate. Rarely in the investing world do you get a chance at a no-lose investment like this, with a relatively small price to pay to hit the "undo" button! So even in Murf's best case scenario where his vision is completely accurate, it is far from certain that resource investing would strongly outperform CDs anyway when reinvestment at higher rates is an option. And if the CD's slightly underperform, again, the peace of mind factor probably makes CD's the better choice.

Another reason to prefer CD's over resource investing is something I've learned the hard way. It is better to be on the side of the government than against it. Despite Ben Bernanke's frantic money printing, the U.S. isn't about to inflate food commodities to the point that the population starves. They aren't about to inflate oil to the point that nobody can commute to work. They are pushing the money printing envelope now in an attempt to restart the economy, but even they know that there are limits. If the Fed ever ends its money printing in a recognition of its failure, something that likely will eventually happen one day, commodity prices will get completely destroyed overnight. Furthermore, and this also plays into my CD strategy, the number one thing that would wreck the housing recovery is a spike in interest rates. The government will keep interest rates low at all costs, even if it means tanking the stock market in the process to force a flight into the safety of U.S. Treasuries. Remember, the government wants both cheap resources and low interest rates. If you buy CD's and avoid resources, you are on the same side as the wishes of our government. If you buy resources and bet on much higher interest rates, you are betting against the goals of our government. The government may not always win its battles, but believe me when I say that being on their side is a far easier path to take in investing!

Lastly, I have long thought that the U.S. will likely follow the path of Japan. Japan has been experiencing deflation for twenty years now, with low interest rates the entire time. Again, I don't believe that soaring interest rates and hyperinflation are right around the corner by any stretch, at least not for the U.S.. I believe that the U.S. already had its inflationary period. That period was from 1982 until 2007. Over that time, look at the price changes of the stock market and of housing, as well other things such as a college education. American has already had its time of rampant inflation, and in my belief, is now going to enter a long period of deflation, or at least a sideways movement in prices. A 4% risk-free return in a deflationary or stagnant environment is a good deal.

This turned out to be longer than I had planned, but I hope people find it helpful. In investing, slow and steady guaranteed returns with no chance of losses very often win the race. In the times when they don't outperform, they also rarely lose the race by a large margin.

Best of luck to everyone, and thanks again to Murf for his efforts here,

John Chinnock

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