eleven to mean to put to the maximum volume. The majority of the bull market in bonds is over because, metaphorically, bonds cannot go to eleven. Where can you go from a 4% interest rate on the 10-year Treasury bond? Nigel Tufnel would respond with nowhere. So perhaps bonds in this environment are not for wimps, but rather for risk-takers.

Protecting Investments from Changing Interest Rates

What are the implications of this analysis for investors? The 20-year bull market in bonds has largely run its course. U.S. bond prices can fall, go sideways, or rise very modestly. The huge gains of the last two decades cannot continue. In addition, it is likely that the inflation adjusted (real) interest rate will rise.

This is a toxic environment for the backward-looking, pattern-seeking lizard brain. Bond prices have risen for the past 20 years, and the lizard brain is built to predict that the trend will continue. Yet we know that interest rates cannot go below zero. Thus, we have a pending collision between the assumption of the lizard brain and economic reality.

The implication is that most of us have too much riding on low interest rates. The lizard brain has been lulled into interest rate overconfi-dence by the unsustainable 20-year bull market of rising bond prices and falling interest rates. Thus, most people should adjust their financial position to have lower exposure to rising interest rates. There are three ways to protect ourselves from interest rate rises.

Tip #1: Borrow at Fixed Rates

Borrowing at fixed interest rates reduces risk. If interest rates rise then it will be great to continue to enjoy todays low rates. If interest rates fall substantially, then it is always possible to refinance. Thus, fixed-rate debt is lower risk than adjustable or floating rate debt.

Tip #2: Lend Short-Term

If you own bonds, you are a lender. The shorter the term of your loan, the less risk you face from interest rate changes. If you own U.S. government bonds, for example, those that mature soon are less risky than those that mature later.

Tip #3: Borrow Less

If the inflation-adjusted interest rate rises, then the burden of debt will increase. One obvious way to decrease the burden of rising rates is to reduce the amount of borrowing. For those with nonmortgage debts, one route is to sell some stocks or other assets and pay off some debt. Those with mortgage debt can prepay a chunk of the principal. (Some mortgages do not allow or reward partial prepayment, but these mortgages can be refinanced if necessary.)

Acting on these tips will reduce risk and position the investor for profit. It is possible to benefit from rising interest rates. The financial media suggest that rising interest rates would hurt the economy with no benefits. This analysis suffers from two flaws.

First, if the economy is strong, interest rates will rise. One of the few ways to have continued low interest rates is to have a recession or worse. U.S. interest rates in the Great Depression were close to zero. Similarly, Japan has enjoyed low interest rates recently because it has suffered through 15 years of economic malaise.

Second, rising interest rates are great for savvy savers. Savers would prefer to get those superhigh interest rates of the early 1980s rather than todays puny returns. In order to profit from a rise in rates, however, it is important to buy bonds after the rates have risen. Thus, implementing the previous tips will position an investor to benefit from rising rates.

Making money in this interest rate environment requires overruling the lizard brain. The correct course now is likely to be the opposite of what has worked for the last generation. The lizard brain has been fooled by 20 golden years of falling interest rates and rising bonds prices.

chapter eight

STOCKS

For the Long Run or for Losers?

If you had $1 million, what would you do with it? My students in the spring of 2001 pondered this question. At the time, I was a visiting professor at my alma mater, the University of Michigan. My roommate from my undergraduate years, Peter Borish, had returned to give a short guest lecture to this class of about 150 college students, many of them majoring in economics.

Peter Borish is a famous and accomplished investor. Before posing this investing question, Peters comments made it clear that he was extremely knowledgeable and sophisticated about the world of finance. Accordingly, the class was a bit tense as many students thought they knew the right answer, but were intimidated. After what seemed like a long time, Gayla, one of the students whom I knew well because she served as an academic liaison between the students and me, broke the silence.

Id buy stocks, I would diversify and try to minimize transaction costs. Accordingly, I would probably not try to pick individual stocks, but