Negative Interest Rates

The Reserve Bank hasn't ruled out the possibility of negative interest rates, a new territory for monetary policy in NZ. Paying borrowers and charging lenders seems to go against common sense. But in Japan and parts of Europe, short-term rates have been negative for quite some time.

This is alarming for some; we fielded many questions on this topic back in 2016. But a good investment strategy is robust in all environments and we believe negative rates alone shouldn't necessitate changes.

It is very unlikely negative rates would be passed on to bank's retail clients, but let's look at the implications if this were the case.


Good plans work in all situations

There are common themes to all plans we work on with clients; the plans all include:

  • An emergency fund in cash for unexpected expenses and peace of mind

  • Cash or term-deposits put aside for short-term spending

  • A mix of well-diversified shares and bonds, providing a balance between returns and stability for goals and comfort levels.

This makes sense in all interest rate environments. Having cash there when you need it is more important than returns, even if you have to pay for the privilege. If you have more cash than you need, it should be invested for your long-term goals.

For example, Rob Stock of Stuff mentions why he kept cash aside while paying his mortgage, even though he was paying more interest:

 
Having some money in cash, for example, while at the same time having a mortgage always seemed economically irrational as banks lend money at higher rates than they pay to borrow it from depositors.

But many people keep a cash buffer, even when they have a home loan. I always did when I had a home loan.

I was willing to pay that cost, as I was willing to invest in KiwiSaver and keep some direct shareholdings, because I wanted to be able to meet all my obligations without having to go cap in hand to the bank for more debt, if I ever had a period of unemployment.
— Rob Stock, Stuff
 

We mentioned in a previous article how to best set-up your different accounts and how much to have in each. In summary:

  • Spending accounts - Keep enough for regular spending and purchases for the next month or so.

  • Savings accounts - You should have an emergency fund in savings, typically 3 - 6 months spending. Also appropriate for goals coming up in around 3 - 6 months.

  • Term deposits - Useful for goals in the next 3 - 18 months, if you are reasonably certain when the money is needed.

  • Shares and bonds - Further than a year into the future, investing in bonds will likely earn you more than term deposits. For your mid-term/long-term goals, get advice on what portfolio is right for your needs.

Notice we never mention returns directly, as the more important factor is risk.

Whether the OCR is set at 0% or 5%, we expect you will earn a little bit more in a savings account, more again in term deposits and even more in bonds or shares. And each step away from cash moves further up the risk ladder.

If you have goals coming up this year, shares are too risky for these funds. For goals still decades away, sitting in cash is a wasted opportunity, and the less risky option means falling short of these goals. This remains true no matter what is happening with interest rates.

Why not keep cold, hard cash?

If you had to pay to have money in the bank, why not keep physical currency?

How much is the convenience of electronic banking worth? Or the safety of not carrying wads of cash in our wallet or in our homes?

You could rent a deposit box for around $20 per month and keep your cash there. Unless you had more than $40,000, with an interest rate of -0.5%, you would be paying more for the box, with the added inconvenience of a physical location to visit.

Another option is purchasing a safe at home, if you think you'd get your money's worth. There is still the added pain of having to pay in cash all the time.

So you could avoid paying interest by withdrawing your cash. We believe the convenience and safety of the bank is worth paying a little interest.

What does it mean for my shares?

In general, rates cuts are considered good for shares and hikes bad. Of course, the main purpose of monetary policy is to change the incentives for consumers to spend and businesses to borrow, controlling inflation and growth. Rate cuts promote spending and cheapen business debt, so we expect business earnings to increase.

This does not apply to all businesses. Banks will feel a negative impact as their interest earnings decrease. Importers may see costs increase if rate cuts weaken the NZD.

Discussing these trends and capitalising on them are two very different things, as markets are constantly factoring in expectations and new information. If a rate change was 100% known beforehand, prices would not change. If it were unexpected, prices would adjust rapidly, offering no chance to benefit from the change after it has happened.

Negative rates are concerning in that their implementation show the great lengths necessary to create growth in the economy. This does not mean a poor investment climate. Japan implemented their negative rate policy way back in January 2016. Over the next four years, their share market index (Nikkei 225) gained more than 7% p.a. excluding dividends.

What does it mean for my bonds?

The return on a bond is tied to interest rates, so with negative rates, newly issued bonds will be less appealing. Short-term, we will likely see prices rise, as bonds that were issued prior now pay more interest than newly issued ones.

This also depends on the expectations of investors. Prices may increase before the change in interest rates if investors see the change coming. Bond markets are very efficient, with strong price movements following unexpected events, not expected ones.

For example, in 2019 we saw a sharp increase in bond prices when the Federal Reserve cut rates in the US. At the time, the commonly held belief was rates couldn't go lower.

Like with shares, the effects are complex. We often see longer-term bonds increase in value while short-term bonds decrease and vice versa. After all, rates cuts are meant to stimulate growth, which may reduce the risk that companies cannot make bond payments.

So for the bonds you already own, the effects will likely be positive short-term. But would it make sense to continue to invest in bonds?

As part of a diversified portfolio, bonds offer stability, offsetting the volatility of shares. This stability remains in a negative rate environment, so no changes are needed in response to rate cuts.

What type of bonds you invest in shouldn't change either, as the decision regarding which to include is based on risk, the stability needed for your situation.

The danger of chasing higher yields

It may be tempting to move up the risk ladder as the returns on bonds is lower. Be very careful, as you don't want to exceed your risk tolerance.

The thing about these risks is you can't control how much you are compensated for accepting them. You essentially get what you are given. If the reward is lower than we would like, it is tempting to seek out more lucrative investments. But risk=reward, and this search for yield leads to risks not aligning with your goals.

Interest rates have been low for quite some time. I find it concerning when I read articles about "the search for yield", like this one from last year by CNN. They suggest two commonly touted strategies to get a bit more from your investments.

First they suggest dividend paying stocks, which is a huge step up the risk ladder from cash or bonds. The risks of owning part of a company are too often dismissed in these articles. Usually this is because the chances of something affecting dividend payments is seen as incredibly unlikely. For this reason, airport stocks were often favoured for steady dividends.

For the first three dividend-paying companies mentioned in that article, here is what happened to their share prices during the February-March downturn:

For a long-term investor, with a well diversified portfolio and a high risk tolerance, this is not the end of the world.

If you had invested in these companies to earn a steady income higher than bonds or cash, this is a terrible outcome. While investment-grade bonds are very unlikely to stop interest payments, it is possible these companies will suffer further or stop dividends altogether.

This dividend-chasing problem has hit some Australian retirees particularly hard, as Peter Mancell, a successful adviser from Tasmania, discusses in this scathing article.

Another alternative suggested is high-yield bonds, better described by their other name, junk bonds.

Junk bonds pay more interest because the companies who issue them are more likely to not make repayments. The probability of being paid in full and on time for investment-grade bonds is higher than 95%. For junk bonds the chance is at best 90%, and much lower for the worst-rated.

Cross the line from investment-grade to junk and the defensive part of your portfolio starts to look more and more like a risky growth investment. The CNN article provided two benchmarks for high-yield bonds. Both approached -25% returns over February/March, similar to the returns of share markets.

Even some local investment managers were hit hard by this, as funds described as "income funds" generated some of their returns from junk bonds.

What should we do with negative rates?

So negative rates aren't the end of the world for shares or bonds. If your cash and investments are already aligned with your goals, it is unlikely you will need to change anything.

If you are concerned that lower returns on cash and bonds may affect your ability to reach your long-term goals, we can discuss changes to your portfolio. However, the only way to achieve higher returns is to accept more risk, which means investing more in shares and less in bonds.

The caveat is, during periods like the first quarter of this year, your investments may fall in value quite rapidly. For experienced, long-term investors, this is acceptable. If you are less experienced, withdrawing from your portfolio, or expect to do so in the near future, this risk may be unacceptable.

Negative interest rates may be the catalyst needed to review your financial plan. A better time to review your plan is always right now.

Buying Low - Walking The Walk

First rule of investing - buy low; sell high.

Everyone understands this rule, but few actually follow it.  In fact, most investors tend to do the opposite, selling low and buying high. Why does it prove so difficult for investors to follow this rule?

Canadian adviser and author Carl Richards describes the difference between average investment performance and the average investor's performance, as the "behaviour gap". The difference is due to investor's tendency to buy and sell at the wrong times, instead of simply holding their investments.

The reasons for this gap are perfectly reasonable. Overcoming this behaviour means addressing core human biases and often making investment decisions that seem to go against common sense.

A few things to note when talking about buying low.


Seeing Trends

One of the many advantages humans have over animals is our ability to identify patterns. Pattern recognition helped our ancestors to remember important locations, spot predators and find resources. It also led to the development of language and our appreciation of music.

Bobby McFerrin demonstrates the power of the pentatonic scale, using audience participation, at the event "Notes & Neurons: In Search of the Common Chorus".

The term apophenia describes our tendency to see patterns where none exist. It is why we see figures in clouds or the man on the moon. It also extends to the logic in conspiracy theories and some odd rituals in our daily routines.

If you tap the top of a beer can before opening it, you are a victim of apophenia. The only reason this stops the beer fizzing is you end up waiting longer before opening it. It becomes a ritual as we falsely attribute the lack of fizzing to the tapping.

When it comes to investing, Random walk theory postulates share price movements are random or driven by unforeseen events. This essentially makes short-term predictions impossible.

But if we see a graph showing share prices going up, we quickly assume they will continue going up, and vice versa. This makes it difficult to buy shares when your instincts are telling you to wait.

The News Will Look Bad

While share markets are falling, the news being released will be overwhelmingly negative. Even when the market has bottomed out, the articles you read will still be about things going wrong. Even professional investment managers will be focusing on whatever key figures that, to them at least, indicate a continued slide or imminent recovery.

Over the last quarter of 2018, share markets fell by a considerable margin. This preceded a year where stock markets gained around 20%. NZ Herald's Liam Dann is an excellent business reporter, but his article from December 2018 has not aged well.

 
The bull market is dead.

As fresh falls this morning take the NZX-50’s returns for 2018 below four per cent, it’s time to recognise the decade-long equity boom we’ve enjoyed is over.

For the foreseeable future we can no longer expect to see double-digit returns on our KiwiSaver funds.
— Liam Dann, NZ Herald
 

The NZX 50 index, representing the NZ share market, hit the bottom the same week this article was published. Over the next quarter, it hit record highs again. Over 2019 it gained more than 30%.

How about CNBC's article titled S&P 500 teeters on edge of a ‘death cross,’ and one key level could determine its next moveWhat exactly a 'death cross' is doesn't really matter, but it sure sounds scary. Especially when commentators are suggesting certain doom. From Nathan Edwards of IMG Wealth Management:

 
The bad news is that there has not been a single bear market in history that was not preceded by, or followed in short order by this indicator.
— Nathan Edwards, IMG Wealth Management
 

In the US, the recovery was also sharp, with the S&P 500 jumping up more than 10% in January. Over 2019 it gained more than 25%.

In the UK, here is the headline for their rolling coverage, last updated at the market bottom, December 19 2018.

Guardian.PNG

Nothing here to be optimistic about! But over the next quarter, the UK share market gained about 8%, modest compared to other countries, yet still a strong recovery.

Here are a few headlines from February and March in 2009, the end of a long share market decline from the GFC:

From here, the S&P 500 would gain more than 50% by the end of the year, and 150% over the next five years.

This makes it tough for investors to buy low. As share markets are going down, you will seldom hear anything positive about the market or economy. To buy at these times seems to go against common sense. So instead it is tempting to sit on the sidelines until things "settle down".

But once things have settled down (if they ever are truly settled down), prices are up again. After all, the factors which drove them down in the first place are what made buying so unappealing in the first place.

The problem is, even for experienced investors, we often mistakenly assume the stock market follows the economy, instead of vice versa. By the time things have seemed to have improved, share prices have long since recovered.

Loss Aversion

CarlRichards190417.jpg

You can't talk investor behaviour without mentioning loss aversion. Put simply, losing something feels about twice as bad as gaining something feels good. Losing $5 is a bigger deal than finding $5.

If you are already invested, a drop in value hurts. Putting more capital in the firing line is a tough ask, especially when you expect trends to continue.

If you aren't invested, the fear of regret is stronger than the fear of missing out. So we don't feel as bad watching a potential investment going up $1,000 from the sidelines as when we watch it go down $1,000 while invested. The decision with less expected regret is to not invest.

Assuming we invest to reach our long-term goals, the two scenarios are the same, only our perspective differs. It seems we are more comfortable than we should be watching markets soar without us. By the time we are ready to dip our toes in, the low prices have gone.

With the benefit of hindsight, the most common investor regret is not investing sooner. A recent survey by personal finance site MagnifyMoney, found about three quarters of the 836 participants regretted waiting to invest in stocks.

Buy Low Doesn't Mean at the Bottom

The problem with waiting for 'the bottom' before buying is we don't know when we get there. There is no bell at the bottom. Often this will be the time you feel least like jumping in. You have watched the stock market go down and expect the trend to continue. The news is talking about everything going wrong.

The level 4 lock-down was announced on March 23. At the time, we didn't know what this would mean for NZ businesses, employment, the economy. It would be understandable to say "I might wait until we know what's going on", or something similar, instead of investing.

March 23 was also the bottom for the NZ stock market, with the last 8 days of March bringing a 15% total gain. This was during a period of huge uncertainty. People were still hoarding toilet paper at this point. Very few would have picked this day as the best time to invest.

Following the GFC, unemployment in the US peaked at 10% in October 2009 while the share market hit the bottom in March. The share market had gained nearly 50% by the time unemployment peaked.

You don't have to call the bottom to get a good deal. If prices drop, you get a discount. If they drop again, you can buy even more shares for the same amount of money. It will hurt to see your previous investment go down in value, but we didn't know that beforehand. What we do know is the discount on shares is even better now.

Ben Carlson explains what buying low really means in his  March 1 article:

 
Buying stocks when they’re rising is easier because every purchase makes you feel like an investing genius. Buying stocks when they’re falling is harder because almost every purchase makes you feel like an investing fool.

Buying stocks when they’re seriously falling, as they are now, rarely feels like the right move.

Every investor is told to buy low and sell high. But most don’t realize that buy low typically works out to buy low, then buy lower, then buy even lower, and once you really hate yourself, buy lower than you thought was possible.
— Ben Carlson, A Wealth of Common Sense
 

How to Consistently Buy Low

So some of the reasons why it is difficult for investors to buy low:

  • We expect downwards trends to continue.

  • All the negative press seems to support this view.

  • We feel more comfortable missing out on gains than suffering losses.

  • We can't time the bottom, and buying as prices fall feels terrible.

All these factors lead investors to wait until prices are high. At this point, we expect markets to continue upwards (more often true than not, to be fair) amidst positive press. With the worst times in the rear-view mirror, the fear of losses is replaced by a fear of missing out.

To avoid these mistakes and benefit from low prices, you need a strategy and discipline.

For those already fully invested, without spare income (or cash) to invest, buying low is a part of rebalancing. When some of your investments do well, such as shares, a strict rebalancing policy means selling these investments to purchase those that have not. Doing so ensures you are regularly buying low and selling high in a disciplined manner. This also ensures the risks you take are consistent over time.

If you are still saving, set up an automatic deposit to invest weekly or monthly. Do not change your savings rate based on what is happening in markets and the news. This ensures you will be purchasing throughout volatile times, and the highs and lows will average out. Remember, it is time in the market, not timing the market that generates returns.

And if you are confident enough to act against your biases in favour of really buying low, consider some of the following additions to your financial plan:

  • If the market drops by X%, I will increase my contributions to $X (or reduce withdrawals to $X).

  • If my portfolio value drops in value over the quarter, I will deposit the amount by which it dropped into the portfolio.

  • If my portfolio value is below what I expected it to be in a given quarter, I will deposit enough to bring my portfolio back to target.

Most importantly, whichever strategy works for you, stick with it. We can't control markets but we can control our decisions. Overcoming your bias and fears of regret now means greater outcomes and less regret in the future.

Modelling - Not Just for Epidemiologists

Over the course of the last few months, we have heard a lot about modelling, as epidemiologists tried to forecast the spread of Covid-19. While some have criticised the validity of these models, it is easy to see their importance. A basic exponential model was a very good predictor before lockdown measures began.

Models are not limited to pandemic responses and complicated experimental research. I would argue they guide how we make decisions in our personal and professional lives. When we buy a house or car, decide on a new job, or pick a place for lunch, subconsciously we go through a checklist of pros and cons.

A statistical model is more precise, allowing us to guess outputs from a few given inputs. While not perfect, these models go a long way in describing many facets in our day-to-day lives.

How we use models when buying cars

What do you look for in a new car? What do you consider when deciding on a fair price?

For used cars at least, the process usually starts the same for everyone. First you go to trademe, look at a few models you like and check the prices. Then you compare the prices against each other.

This one is a 2010, but it has low k's. This one seems like a good deal, but I'm not fond of neon green. This one is almost perfect, but I'd rather it had the flat-screen in the dash.

All of these features influence what you would be willing to pay for each car. This is done mostly subconsciously; instead of discounting a few cents for each k on the car, we tend to factor it into our ballpark figures.

But this is similar to what a statistical model would do. With a perfect model, you would put in all the factors which affect the price and, voila, you get the value of the car.

Unfortunately, perfect models don't exist for practical applications, which is why weather forecasters aren't always on the money. Good models still explain a lot. The better the model, the more it explains.

When it comes to used cars, some statisticians have thrown together models to estimate prices. I actually had to study this myself in my university stats class. I found one example online where the analysis only included four variables:

  1. Mileage

  2. Year

  3. Whether it came with the tech upgrade

  4. Whether it included a mechanics report

These four factors explained 90% of the price, with the other 10% unaccounted for. This is possibly explained by condition, colour, location etc. However there is also going to be some variation as people negotiate on price. For a ballpark figure, this is a helpful result.

For the cars included in their sample, they estimated a car with zero miles, from the current year, without the tech upgrade or mechanics report costs about US$27,500. Each mile on the clock discounted the price by about 6 cents. Each additional year discounted it by about $1,300. And including the tech and report added about $1,500.

So a 5 year old car with 200,000 miles, no bells and whistles? Expect to pay around US$9,000.

Share price modelling

This same modelling process can be applied to share prices and returns, if we have the factors needed.

The most widely known model is the CAPM (Capital Asset Pricing Model). Essentially it only considers a share's volatility compared to the market as a whole. You start with a risk-free return, like that of cash, and add on the return implied by the share's volatility.

This is like the example above, where we started with the value of a current year car with no miles, then discounted the price based on the number of miles.

The CAPM model explains about 70% of returns, pretty good with only one factor! Obviously, with something as complicated as the share market, we need a few more variables to explain returns.

In 1992, Eugene Fama and Ken French developed the Fama-French Three-Factor Model, adding two more factors to the CAPM. From the Wikipedia page:

Fama and French started with the observation that two classes of stocks have tended to do better than the market as a whole: (i) small caps and (ii) stocks with a high book-to-market ratio (B/P, customarily called value stocks, contrasted with growth stocks).
— Wikipedia page for Three-Factor Model

They noticed small company shares do better over time, along with those of value companies. Value companies are those with a high value of assets on the books when compared to the value of their shares, hence a high book-to-market.

Adding these two extra factors meant the model now explained more than 90% of a share portfolio's returns. Not perfect, but incredibly informative nonetheless. Eugene Fama went on to share the 2013 Nobel Price for Economics because of this important work.

Why is this important?

The first advantage is clear. If we know key factors driving share returns, we can build portfolios around these factors. This is the foundation of Dimensional's philosophy, building evidence-based investment strategies.

But this model doesn't just explain the returns of Dimensional's portfolios, it explains the returns of all share portfolios.

In our car example, 90% of a car's price was explained by mileage, year, tech and availability of a mechanic's report. The remaining 10% of the price could be due to unknown factors, like condition or colour. There will always be a bit of random variation on top of this.

If we know how exposed a portfolio is to small companies and value companies, we can explain 90% of the returns received. The remaining 10% is due to unknown factors, the decisions of the manager and some random variation.

Once we have accounted for small and value, we can see whether an active portfolio manager is adding to performance through their decisions. Unsurprisingly, we find the absence of any such outperformance.

Bart Frijns, AUT professor and director of the Auckland Centre for Financial Research, investigated KiwiSaver growth funds for a 2016 paper. He used the three-factor model to see if any funds outperformed after accounting for the 90% of returns the model explained. His findings:

This paper found that there is no evidence of systematic risk-adjusted outperformance of KiwiSaver Growth funds, and in several cases, there is evidence of significant underperformance. This paper further reports substantial variation in the amount of risk-taking, and local and international stock market exposure of KiwiSaver Growth funds.
— On the performance of KiwiSaver funds; Frijns, Tourani-Rad

Put simply, there was no evidence active management added any value, once you factor in the 90% of returns explained by the model. The 10% that isn't explained is supposedly where active management can make the difference, but there was no evidence to suggest they did.

This implies the returns of KiwiSaver funds in New Zealand is explained by the risks they take, the fees they charge and a bit of chance. There may be a few more factors which are not yet known, but again, there is no evidence active managers have been taking advantage of these unknown factors.

To add to this, another Bart Frijns paper, published in 2018, found active managers were ignoring these factors when making investment decisions:

Funds show little tendency to bet on any of the main characteristics known to predict stock returns, such as size, book-to-market and momentum.
— A new perspective on the performance of New Zealand actively managed funds; Frijns, Indriawan

We choose to ignore the unexplained 10% in favour of the 90% explained by known factors, avoiding the high fees of active management. This can be done with index-like strategies, based around the proven factors of higher returns.