Record low interest rates have received a great deal of attention in recent weeks. Short term rates are driven by the fed funds target rate, which has remained at or below 0.25 percent since December 2008. On the long end of the yield curve, as August drew to a close the 30 year U.S. Treasury bond was providing a nominal yield of only 3.6 percent, less than half its daily average since early 1977.

Media attention has focused on the Fed, which has explicitly committed to an easy money policy amidst a faltering recovery, and financial institutions, which have been reluctant to extend credit despite abundant liquidity. The plight of businesses, faced with an increasingly tenuous economic recovery and an uncertain future regarding regulation and taxes, has also been well publicized.

The immediate implications of falling interest rates for consumers and investors, however, have received less attention. Though the opportunity for homeowners to refinance their mortgages has been widely covered, the negative impact of low interest rates for individuals, particularly for older investors who rely heavily on fixed income, has by comparison received little attention.

The table below displays recent (annualized) yields provided by several conventional short term fixed income and cash equivalent investments. Annual price inflation (based on the consumer price index, year-over-year) currently stands at 1.21 percent. While this is low by historical standards, the reality for investors is clear: short term fixed income investments are providing negative real returns.

Even the most conservative investors should have exposure to equities as an alternative source of funds. In order to generate cash to meet living expenses, such investors can sell off a “slice” of their entire portfolio proportionally across asset classes, so that their portfolio’s allocation after the sale matches their target allocation plan (see the July 2010 Investment Guide for our recommended portfolio allocations). In times such as these, when interest income is scarce and equity markets are volatile, this can result in rapid depletion of capital. In our estimation, however, this strategy is superior to many of the structured products being pushed on unwary investors. Investors should avoid solicitations that offer the quintessential free lunch — an unlimited “upside” with no risk of loss.

Current monetary and fiscal policies and the present economic environment have effectively forced savers to assume greater risk. In these circumstances it is imperative that conservative investors maximize their diversification within each asset class in order to avoid company specific and industry risks, which do not compensate investors with offsetting positive expected returns. The low-cost mutual funds listed on the back page of this publication are ideal for this purpose.

Also in This Issue:

The Siren’s Call for Morningstar Ratings: Avoid Temptation
How To Start a High-Yield Dow Portfolio
The High-Yield Dow Investment Strategy
World Market Capitalization
Recent Market Statistics
The Dow-Jones Industrials Ranked by Yield
Asset Class Investment Vehicles