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have to become undervalued (and scorned by experts) before its decline
can end.

How to Invest in a World with
Fluctuating Exchange Rates

Cartoon characters have neat tricks that help them avoid disaster. When
one of our heroes is trapped in a falling house, the solution is simple. Just
as the house is about to crash into the ground, Bugs, Daffy, the Road
Runner, and others simply step out of the house. They walk away from
the wreck with nary a scratch.
While we cannot exit falling houses without injury, we can leave
behind declining currencies. For the last few years, my wife and I have
owned a good-sized position in bonds issued by the German Central
Bank. The bonds pay low interest rates of no more than 4.5% annually. In
spite of the low interest rates we have been earning more than 10% a year
on our German bonds.
The payoff from owning euro bonds is the interest rate plus the change
in the currency. For example, we bought some of these German bonds in
2001. At the time each U.S. dollar bought 1.1 euros. For each $1,000 that
we invested we received more than 1,100 euros™ worth of bonds. When
those bonds matured a year later, the 1,100 euros had grown to 1,133 euros
(3% interest rate). Furthermore the dollar had declined in value so the dol-
lar value was almost $1,150. So in one year these euro bonds earned 3%
interest plus more than 10% in currency change for a 15% return.
To avoid being hurt by a falling U.S. currency, the goal is to escape the
falling house. The protection is to own investments in nondollar curren-
cies. A simple and effective solution is to buy non-U.S. stocks and non-
U.S. bonds.
Deficits and Dollars 135

There are two subtleties to this guidance. First, a company™s exposure
to the dollar is not determined by the location of its corporate headquar-
ters. For example, Toyota may have more exposure to the U.S. dollar than
does Microsoft. Toyota sells a lot of cars in the United States, and
Microsoft sells lots of software outside the United States. So the defini-
tion of a non-U.S. stock depends on the location of sales.
Second, a declining dollar puts pressure on foreign companies. For
example, the weakening dollar has made German goods less attractive
and consequently fewer German workers have jobs. Remember that the
U.S. current account shrinks when Americans stop buying Italian hand-
bags and German cars. That means the companies who make Italian
handbags and German cars need fewer workers. The savvy investor has
to escape the effects of the falling dollar both within the United States
and in other countries.
How much should be invested in nondollar assets? My advice for the
average investor is 15% of net worth. To minimize risk of currency fluc-
tuations, I suggest that people align their investments with their buying
behavior. For example, the average American spends about 15% of her or
his income on foreign goods. Thus, a completely reasonable, and low-
risk strategy suggests that 15% of an investor™s net worth be invested in
nondollar assets. Those who want to speculate with me on a further dol-
lar decline, and those with a taste for foreign goods, could allocate even
more to foreign investments.

and Art to
Bonds, Stocks,
and Real Estate
138 Applying Science and Art to Bonds, Stocks, and Real Estate

n Part Three, we evaluate the prospects for bonds, stocks, and real
estate. In Part One, we learned that markets are far from rational.
Thus, we cannot rely upon the world to ensure prices are fair. In Part
Two we examined the macroeconomic forces driving investments.
In this section, we evaluate investments using the science of irra-
tionality, including our understanding of the lizard brain, and the art of
With these two complementary tools, we turn our attention to the most
important financial investments. In Chapter 7, we examine bonds, and
ask if interest rates are going to rise substantially. In Chapter 8, we eval-
uate the stock market. Has the bull market in stocks returned, or is the
early twenty-first century stock market rally a trap? In Chapter 9, we
evaluate real estate and ask if there is a housing bubble.
In The Meaning of Life, the Monty Python comedians start by asking,
“What™s it all about?” In answer, the movie provides humorous perspec-
tives on ponderous subjects including birth, conflict, old age, and death,
and concludes with:

Well, that™s the end of the film. Now, here™s the meaning of life. . . .
Well, it™s nothing very special. Uh, try and be nice to people, avoid
eating fat, read a good book every now and then, get some walking
in, and try and live together in peace and harmony with people of all
creeds and nations.

After a tumultuous film, “be nice to people” might seem a bit obvious.
Similarly, the “sell long-term bonds” advice in this section might appear
modest. After brain scans, chimpanzee productivity, and seashell arbitrage,
can™t the new science of irrationality say more? Absolutely. The final two
chapters of this book provide novel and surprising advice on how to out-
smart the lizard brain. This innovative “logic of the lizard” approach builds
on the clear evaluations of bonds, stocks, and houses of this section.
chapter seven

Are They Only for Wimps?

U.S. History Has Favored the Bold

“Bonds are for wimps!” So declared Harvard Professor Greg Mankiw in
1993 when I was a Ph.D. student in his macroeconomics class. Professor
Mankiw is not only a world-class researcher, but also a great communica-
tor. I found him to be an excellent teacher, and his ability to make econom-
ics interesting has allowed him to write several best-selling textbooks.
When Professor Mankiw said, “Bonds are for wimps,” I don™t think he
was making an investment recommendation. Rather he was being a great
teacher by using colorful phrasing instead of using the technical term
“the equity premium puzzle.”1
The academic research on the equity premium puzzle examines the
money that has been made in U.S. stocks and U.S bonds. What was the
conclusion of this research as of 1993? Bond investing had provided safe,
but unspectacular, returns. Over the history of the United States, those
investors willing to take a flyer on risky stocks would have made much
more money than bond investors, even when adjusting for the more
volatile nature of stocks. With the benefit of hindsight, therefore, only the

140 Applying Science and Art to Bonds, Stocks, and Real Estate

extremely timid (a.k.a. the wimps) ought to have chosen U.S. bonds over
U.S. stocks.2
Warning: Past performance is no guarantee of future returns. Every
mutual fund has such a disclaimer. All of the research summarized by
Professor Mankiw examined the past. In 1993, it was true that through-
out the past, U.S. bonds had been worse investments than U.S. stocks.
Obviously, investors ought to care about the future not the past. Accord-
ingly, this chapter analyzes the outlook for bonds, not just past performance.
Before starting on our bond journey, a few preliminaries are required.
First, we™re going to look at only U.S. government bonds. The bond uni-
verse encompasses many other bonds including junk bonds, municipal
bonds, and many more. Why do we only cover government bonds?
Because of the story of the goat.
Two men go to a car junkyard looking for spare parts for a classic
vehicle. The junkyard is large, so the owner suggests that the men look
around to see if they can find a junked car with the needed parts. Inter-
estingly, the owner warns the men to look out for his pet goat.
During their walk through the junkyard, the men pass a hole in the
ground. One of them kicks a pebble into the hole and both are surprised
that they do not hear the pebble hit bottom.
As might be predicted, the men forget their spare parts mission and
begin throwing larger and larger items into the apparently bottomless
hole. After some minutes, and still unable to hear anything hit bottom,
they heave a transmission into the hole. Soon afterwards, a goat runs up
to the side of the hole, pauses, and then jumps into the hole. Shaken by
the goat™s apparent suicide, the men return to the junkyard owner.
“Did you find your parts?” the owner inquires. Without mentioning the
items they had thrown in the hole, the men tell the owner about the goat
that jumped to his death. The owner says, “That™s funny, but it couldn™t
have been my goat, as mine was securely tethered to a transmission.”

In the bond world, U.S. government bonds are like the car transmission
while all other bonds are the goat. If U.S. government bonds sink in
Bonds 141

value, they will drag all other bonds down with them. There might be
some delay while the other bonds teeter on the edge, and some goats may
have longer ropes than others. Nevertheless, if U.S. government bonds
decline in value, so will all other U.S. bonds.
What about the possibility that bond prices will soar? As we will see,
that is not possible. In the current environment, bond prices can either fall
or perhaps rise modestly. The first message in this chapter is: U.S. gov-
ernment bonds will measure the speed and length of any decline in the
bond market. Thus, we keep our eye fixed on these bonds.
The second message is: Bond prices move in the opposite direction of
interest rates. In other words, rising interest rates are bad for bond owners.
Why are rising interest rates bad for bondholders? This can be confus-
ing, and the reason for the confusion is as follows. Is it better to earn 4%
or 8% on a bond? The answer is obvious; the 8% bond is better. So rising
interest rates might seem good for bondholders. The answer is exactly the
opposite: Rising interest rates are bad for bond owners. Falling interest
rates are good for bond owners.
The potential confusion is resolved by clearly separating today™s bond
prices from future returns on bonds. My friend Chris (the MIT rocket sci-
entist we met earlier) and I recently had a similar revelation in a nonfi-
nancial situation. Chris is a great athlete and better than I at every
sporting activity we have played, at least until recently. A frigid Boston
winter forced us indoors, and we decided to begin playing racquetball.
Because I had played a lot of racquetball previously, I soundly beat Chris
during our first match.
After the drubbing, Chris was a bit morose, especially given his his-
tory of outrunning and outplaying me in a variety of sports. I said, “Los-
ing badly was the best possible outcome for you.” When he asked me to
explain, I said that he had nowhere to go but up. As we continued to play
each other in a series of matches, Chris performed steadily better. Our
first match was a short-term defeat for Chris, but set him up for months
of steady progress. The worse he did in the initial match, the better his
prospects for improvement.
A similar situation exists for bonds, especially government bonds. The
142 Applying Science and Art to Bonds, Stocks, and Real Estate

lower a government bond™s current value, the more it will grow until
maturity. An old joke asks, what™s the difference between men and
bonds? The answer is that bonds eventually mature. Not only do all U.S.
government bonds mature, they mature exactly on schedule and at a price
of exactly $100. Thus, the lower the current price of a U.S. government
bond, the more gains to the eventual price at maturity of $100. Lower
bond prices mean higher future returns. Similarly, higher bond prices
mean lower future returns.
When interest rates go up, bond prices go down. When interest rates
go down, bond prices go up.
Another way to look at bonds is to divide current owners from possi-
ble buyers in the future. If, for example, home prices were to plummet,
that would be bad for current homeowners but good for future buyers.
Similarly, a drop in bond prices is bad for current bond owners, but good
for future bond buyers.
The decision to invest in bonds rests upon a prediction about the direc-
tion of interest rates. Buyers of bonds are betting that interest rates will
remain stable or decline. Those who believe interest rates will rise should
avoid owning bonds. Accordingly, the mission of this chapter is to exam-
ine the future of U.S. interest rates.

Revenge of the Bond Wimps

In 1993, Professor Mankiw said bonds were for wimps because the eco-
nomic research suggested that brave investors ought buy stocks.
While bonds may be for wimps, those wimps who bought bonds in 1993
had very good outcomes”perhaps better than if they had bought stocks. In
the time since the “bonds are for wimps” statement, the total amount
earned from buying U.S. Treasury bonds has been almost the same as from
buying stocks. Furthermore, those who bought bonds knew that the U.S.
federal government would pay them back. Stock owners took big risks,
which included two consecutive years of serious stock market declines.
Bonds 143

In recent decades, bonds have been the profitable tortoises to the prof-
ligate hares of the stock market. In fact, the good years to have bought
bonds started in the early 1980s, more than 10 years before Professor
Mankiw said bonds were for wimps. Interest rates over the last 20-plus
years have seen a persistent and powerful decline (see Figure 7.1).
Accordingly, bond owners have been handsomely rewarded for more
than 20 years.
I remember reading a magazine article in the early 1980s that sug-
gested buying what it labeled the Reagan bonds. These were long-term
U.S. government bonds with interest rates significantly above 10%. I
took note of the argument neither because I believed it nor because I was
going to buy the Reagan bonds. I took note because the article seemed so
Consistent with the theme of this book, bonds were a great buy at pre-
cisely the time they were hated. In the late 1970s and early 1980s, the hot
investment themes were real assets, including gold, jewels, land, and
impressionist paintings. In a time of inflation, everyone knew that bonds
were for idiots (and probably wimpy idiots at that).


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