04/05/2011 07:10 pm ET Updated Jun 05, 2011

Mega-Deficits and Your Investment Portfolio

As of April 2, 20011, the outstanding public debt of the U.S. was in excess of $14 trillion. Your share of this debt is more than $46,000. The U.S. debt level is approximately 90% of its economic output.

Many investors view the rising debt as having major implications for their U.S. based investments. On the surface, this concern makes perfect sense. Why would you want to invest in a country that can't live within its means? Isn't it obvious the whole deck of cards is about to come crashing down?

Marlena Lea, a Vice-President of Dimensional Fund Advisors examined this issue in a thoughtful research paper. Her research considered the economic and investment ramifications of fiscal deficits.

As expected, she found that deficits are related to higher long term interest rates. This makes perfect sense. As deficits increase, the risk of default also increases. It becomes more expensive to borrow money.

High deficits may also stifle long-run economic growth. No surprise here. Budget deficits decrease national savings, which reduces investment in the domestic economy and increases foreign borrowing. Lower domestic investment leads to lower growth.

You would think high interest rates and slow growth would be the perfect storm for investors. You would be wrong.

Ms. Lea looked at the average annual returns in high and low growth countries in developed markets from 1971-2008. The low-growth countries had an average annual return of 13.52%, compared to 12.90% for the high-growth countries.

The difference was more stark in the returns of countries in emerging markets. For the period from 2001-2008, the average annual return of low-growth countries was 24.62%, compared to 19.77% for high-growth countries.

Ms. Lea concluded that deficits do not predict stock or bond returns and that low future economic growth does not mean low future stock returns, which is precisely the opposite of what most investors believe.

What about currency depreciation? Many investors believe large fiscal deficits are a precursor of currency depreciation. This concern makes sense. The likelihood of inflation and default risk could cause investors to flee the dollar for safer, more stable currencies. The data does not support this view. U.S. deficits increased significantly from 1970-1990. The dollar got stronger, not weaker. The academic data indicates that exchange rates move randomly. Fortunes have been lost in the futile effort to predict currency returns.

Ms. Lea is a highly credentialed academic. She has a Ph.D in finance from the University of Chicago, an MS in agricultural and resource economics and a BS in managerial economics. Most investors would not consider having heart surgery performed by someone without stellar credentials. Yet, they entrust their life savings to their friendly "investment professionals" who base their recommendations on little more than the direction of the wind on a given day. Many of them have no formal training in economics or finance.

There is a vast amount of peer reviewed academic literature which debunks the common investment myths you hear in the financial media and from your "market beating" broker or advisor. Investing your money responsibly requires some effort to familiarize yourself with it, or with books summarizing this research. As for the latter, my books and those by John Bogle, William Bernstein, Burton Malkiel, Mark Hebner, Larry Swedroe, David Swenson and Allan Roth are a good place to start.

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