The Good, The Bad, And The Ugly

Q: Thanks for the excellent review, Alan. It reminded me of a lot of things I had forgotten, as well as things I never realized in the first place. Carter did indeed inherit the long-term results of LBJ's disastrous "guns and butter" policy. LBJ's Great Society entitlement programs have festooned themselves upon the Federal government, and remain even today. I can give Carter kinda, sorta a pass on the economic problems, but his foreign policy blunders were all his own doing. He still continues to this day, sucking up to foreign Totalitarians all over the world. Maybe not the worst President of the 20th Century, but sure as Hell the worst ex-president. forget that a leveraged bet on the housing market is one of the best you can make in an inflationary environment. why are you advising us to pay off debt with low rates of interest relative to both the expected rate of inflation and our expected rate of return?

A: I am not doing that. I think I made it perfectly clear that both the tax deductibility of mortgage interest and the leveraging of home equity argue against paying off a mortgage. With respect to higher interest rate credit card debt, the situation is more complex. If you believe the prospective rate of inflation exceeds the interest rate you are paying, then you should obviously defer repayment. If you have prospective investments whose expected rate of return exceeds the interest rate you are paying, you should obviously use available funds to make those investments, rather than pay the debt. However, there is another factor to consider -- the factor of risk. Leveraged positions are inherently riskier than non-leveraged positions. We see that in buying stock on margin. We see that with homeowners with large mortgages when the property value declines. We see that with banks making highly leveraged investments in financial derivatives. You may think inflation will be much higher in the future, but that may not turn out to be the case. You may think your investments in gold mining stocks or whatever will have a high rate of return, but that may not turn out to be the case. Deleveraging by paying off debts will reduce your expected return if your expected scenarios are realized, but paying off debt also reduces risk, since you cannot be certain about what the future holds. Making actual investment decisions requires that you quantify both expected return and risk. The easiest way to quantify risk is to compute or estimate the standard deviation of expected returns, then compute the return/risk ratio. The optimal investment decision will maximize the return/risk ratio. When you make several investments with similar expected return, and these investments have low correlation coefficients, then the standard deviation of the expected returns on your total portfolio is reduced, so the return/risk ratio is increased. This is basic portfolio theory. I don't think the average investor can make investment decisions with a greater rate of return than the interest rate they are paying on their credit cards. That's why I recommend that all but the most sophisticated investors, such as yourself, pay off credit cards before making speculative, risky investments like gold mining stocks. Even sophisticated investors, such as yourself, will reduce risk by deleveraging. Believe me, if you invest in gold mining stocks, especially on margin, you are exposing yourself to plenty of risk.

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