What keeps this financial planner awake at night? Currently, it’s thoughts about “the anchoring fallacy” and the impact it can have on money and plans for the future.
Interest rate jitters are overdue
Even thought i am writing about interest rate jitters and why they are keeping me awake at night, we’ll start with a quick discussion on “Anchoring bias” – it’s our very human tendency to frame thoughts on a subject around our initial impression or interpretation. The best way of understanding “anchoring bias” is to consider the sale price of a family home. If the asking price is $700,000 then you will base your price negotiations from that figure rather than from an objective assessment. Another is to try to imagine what the future may look like – most likely, you’ll have trouble separating your projections of today’s more familiar trends from the less intuitive future trends – that are most likely going to be completely unrelated to today’s circumstances!
In other words, your thinking is “anchored” in your current understanding and outlook, and it is extremely difficult to look outside of that box. There are many, many examples of this mistaken thinking but my sleep is currently interrupted by the impact anchoring bias has on assumptions about interest rates, and from that, how we view the pricing for all investments today. And by “we”, i mean you, investment managers, analysts, media commentators and (heaven forbid..) even myself!
All of this discussion on interest rates is important because the US Federal Reserve has been reducing the monthly increase in its balance sheet (also known as “QE” or monetary easing or printing money). In fact, they are due to stop this QE by the end of the year. You may say “so what?” but the US interest rate and changes to it will impact on pretty much everything financial – so thinking people in financial markets are wondering what happens next? Do we have a gradual return to “normality” through slow interest rate rises or do we see large increases and a more volatile world? The worry is that future interest rate assumptions are possibly too firmly anchored in the historically the current very, very, very low interest rates. It helps to remember that US rates are at levels last seen during the Civil War, while UK rates are the lowest in 400 years, with Japanese and European interest rates bordering on negative!
Here’s a bit of discussion on how i think anchoring bias is making investment decisions today much more prone to error than they have been for a very long time…
The “search for yield”
Financial media tell me that current low interest rates from cash and term deposits are apparently “forcing” many people to seek higher yielding investments. In many cases, those “higher yielding investments” are higher risk credit securities or volatile shares and/or property exposures. In other words, people who take this extra risk to obtain extra “yield or income” have been fooled into thinking that they have no choice. Hence my inverted commas around “forcing” at the beginning of this paragraph. In reality, no-one is forcing a person to take on more risk. The only “forcing” is the fear that today’s low deposit interest rates will not rise any time soon.
I am not attempting to appear clever’er than the experts and respected commentators out there in media land when i say this. Rather, i am attempting to highlight one of the tricks of financial markets that can lure people to taking bigger bets than they would really prefer.Here’s an example…
Let’s say a person with $400,000 is looking at their 3.8% term deposit rate and worrying that this really isn’t enough for them to live on. After all, they will only earn $15,200 interest in a full year. The advantage of a term deposit though, is that you still have your $400,000 at the end of the year. As a financial planner, even that calculation is optimistic, as it assumes the investor can somehow pay their living costs for the first year before receiving the interest.
For most people, the interest earned is simply not enough to pay for food bills, rates, electricity, gas, insurances, health cover, petrol, registration, telephone, and home maintenance bills. Never mind the cost of clothing, and the occasional meal out. You can forget about Christmas, birthday and anniversary gifts and holidays are out of the question!
What to do?
Interest rate jitters are leading to higher risk-taking behaviour
A lot of experts are pointing to high yielding shares as an alternative. The Big 4 banks and Telstra are paying healthy dividends, which have the added benefit of dividend imputation tax credits. The banks and Telstra today offer something between 4.7% and 5.7% in dividends. If we include tax credits that will lift the return to something between 6.7% and 8.1%. Our $400,000 will now earn something between $26,800 and $32,400. The higher income returns will go a long way towards meeting those living costs and might even help preserve some of the original capital. All well and good. The recent experience is even better, as the value of the $400,000 in shares would have increased in value as well!
What has really happened here though, is that a person has decided that their $400,000 capital isn’t really that important any more. When making this investment, they have agreed to accept a complete loss of control of the capital value of their money. Shares can, and have, dropped precipitously. How comfortable would that person be if they were to wake up one day and find that their shares were only worth $300,000?
Some people will say they have “stop loss” sell orders in place so that they will only lose say 10% if the shares were to fall in value. That’s still 10%. And once the money is back in cash, there is the worry about what to do to gain the income that is required to live…
It’s a difficult situation and one with no simple answers.
Risky assets parading as safe investments…
The way anchoring fallacy impacts us here is through valuations. Income earning assets such as long term interest securities, shares and property can be valued a number of ways – but one of the most common is to value the ongoing income against a low or nil-risk alternative, such as the government bond rate or the cash rate. Cash and bond rates are at historical low points. So anyone looking to purchase these assets today should be asking themselves how those assets will be priced when interest rates are higher than today. What if they are substantially higher? Failure to think through the impact of higher interest rates increases the chances of nasty surprises at some time in the future.
If a person moves money out of cash or guaranteed investments and into volatile areas in order to gain an extra 4% or so a year, what risks are they really taking?
If interest rates are much higher in say 3 years time then they have gained 12% of extra income but at what cost to their capital? What will happen to the value of income paying shares and property if interest rates for low-risk cash and term deposits are a lot higher? What if the value of those investments were to fall more than 12%? If rates rise then the person who moved to higher risk areas would have been better off coping with the lower income from their cash investments and being a little more patient.
In my ever-so-humble opinion, many of the people who have purchased listed “hybrid securities” in the recent past are going to find that these investments aren’t necessarily as “safe” as their promoters suggested they were…
Risk is not being priced correctly
What keeps me awake at night is that this ‘anchoring fallacy’ appears to be just as prevalent in the financial community as it is in the world of non-financial people.
The last time the world looked like this was when i peered out of my office pillarbox at a pre-global-financial-crisis world, in which institutions were offering higher risk borrowers less than a percent as a risk premium over higher credit-rated borrowers. And guess what? That exact same position is occurring today!Take the interest rates being offered on government bonds issued by Portugal, Italy, Greece and Spain. Remember that horrid term “PIGS” that was applied to these European countries during the worst of the “Euro crisis”? Would it surprise you to know that the interest rates on government bonds issued by some of these countries is now on par with or even lower than that of Australia? Spanish bonds running at around 2.54% while Australian bonds offer 3.64%. In other words, there is virtually no risk being priced into these investments. No risk! How on earth can that be justified so soon after we were all told to sell the children and stash the proceeds in a sack with a gun and a tin of baked beans, and hide them away in the back garden? Can you believe the change in cost for borrowings for the Spanish government? How about if we add in the estimated cost for Greek government debt (which i believe to be a defacto style index while the Greek government attempt to return to “normal” market pricing mechanisms).
Don’t fret too much, as all is not yet lost!
i have attended two fund manager updates recently, and both have used the opportunity to highlight the risks posed by global interest rates, and to set out the steps they have taken to reduce the risks in their portfolios (to the extent that they can given their relative mandates). Colonial First State take a “growth management style” approach to investment, so they are looking at who is likely to win or lose from any interest rate adjustments. Magellan global asset management can be seen as a “value management style” with a stronger focus on protecting capital in falling markets – and have adjusted their allocations to cash accordingly. These are just two of the managers that i am seeing take a very proactive approach to dealing with interest rate jitters across markets.
The US 10 year government bond yield has increased from 2.344% on the 1st September to 2.609% on the 12th September, which is a large movement for such a short time. Let’s hope that markets can continue to adjust in a way that is not too chaotic. We certainly don’t want a repeat of 1994, where “safe” government bonds saw large losses in capital value. Now that would certainly keep a lot of people awake at night!
DISCLAIMER : Remember the Great Disclaimer of this blogsite and my Facebook page – nothing here is to be taken as personal advice. It is (very) general thought and musings only. You couldn’t really even call it general advice, as all i’m really saying in this post is to be careful, and to make investment decisions only after having a good poke at the alternatives and the risks you are taking.
You should also keep in mind that interest rates may stay flat or low for many years to come. Back in the 1960’s, interest rates stayed at about this level for most of the decade.
i have even less idea of what the future holds than your average tea leaf at the bottom of a tea cup, so you certainly should not put much store by my musings and ponderings. It’s fine to adore my posts as the musings of a genius, and if you do then i really am flattered – but remember that my genius holds limits – and there ain’t no person in this world that can tell you what tomorrow will look like, never mind predicting the future for something as intricate and interlaced as global financial markets!
As usual, any comment, criticism or query is welcomed, even if sometimes ignored.