In today’s world of financial repression expressed in negative real interest rates, investors are being forced to consider risks they might not normally have taken.
This is especially true for individuals who are close to, going into or already in retirement.
The problem is most acute for investors whose capital is limited and are required to provide or supplement income.
Where did it all begin?
The traditional definition of financial repression covered (often cynical) efforts by governments to channel funds to themselves, such as through exchange controls, prescribed assets, explicit capping of interest rates and other measures.
However the global crisis of 2008 saw the advent of quantitative easing, notably large scale purchases of assets by central banks (such as the Fed), which had the effect of forcing rates down to very low levels. This unprecedented action has led to a new form of financial repression.
Gone are the days when interest rates were real; (above inflation) and prudent investors could hold a large part of their retirement assets in bonds, cash or high quality property, leaving a small portion for higher risk growth assets.
Are investors paying the price?
There is a good argument to be made that the prudent, responsible investor of the last decade is being punished by central bank policies seeking to re-inflate economies in order to erode away debt burdens.
That being said there is little chance that current policies are going to reverse in the short or medium term and investors need to accept the status quo and plan accordingly.
To compound the problem, the bipolar nature of today’s investment world makes it very difficult to invest confidently. Never before in my career (18 years) can I remember a period when both bears and bulls have had such credible arguments.
The bear camp, led by some strong intellectuals and high profile markets commentators, point to lower returns; for years to come, reversions in earnings, deflation then inflation and, at the extreme, a collapse of the financial system. With 2008 still fresh in our minds, it is hard to discount these arguments both academically and emotionally.
The bulls, also led by some very competent commentators and academics (yes in the investment world you can be smart and wrong as one of the two camps will be), point to the return of animal spirits, the improving US economy and a successful conclusion to Fed chairman Ben Bernanke’s policies as signs of strong equity returns and an escape from the debt trap.
Coping in a bipolar world
The predicament detailed above, coupled with human nature (one does not want to accept lower returns and a possible decline in capital or living standards), makes financial planning very difficult.
Perhaps now more than ever, professional advice is required to help deal with the emotions that go with a bipolar investment world and the volatility that accompanies it. Much of how one invests is going to be determined by the amount of capital risk that one can assume.
The balance of this article will focus on the retired investor or the investor approaching retirement.
Perhaps the worst mistake an investor can make is to reach for return in the hope that risk assets will appreciate at a rate higher than inflation and compensate for low cash returns.
While this might work, it does place the investor in an untenable position if his or her capital declines and income is still required from the capital.
Significant capital declines while one is drawing an income will result in a lower balance off which to recover when the market improves.
For example an investor who draws 8% off a share portfolio (3% in dividends and 5% from capital) will only have 80% of their capital remaining after one year if the market falls by 15%. If a second negative year (10% market fall and same income requirement is experienced the remaining capital is balance 67% of the initial (assuming dividend remains the same). In order to get back to the starting capital the third year’s market appreciation needs to be 49%.
Locking into low rate annuities at this point in time may also turn out to be a disastrous decision as an investor cannot assume that inflation has been permanently tamed and that interest rates will remain low in the medium and longer terms.
How then does an investor deal with the problem?
Some possible solutions available to investors in this position are:
- Recognise the situation and reduce your income, accepting a lower living standard.
- Look for “smart risk” but accept the volatility that comes with this. Essentially you are looking for assets that generate an income in excess of cash where there is little risk of permanent loss of capital. Examples of such assets include the equity and bonds of high quality companies and high quality property portfolios with a low debt to equity ratio. If markets for risk asset recover strongly investors will likely underperform index funds.
- Look to trade capital for sustainable income while not accepting higher levels of risk. The net effect of this is normally lower capital transfers to beneficiaries. The risk is not managing the drawdown process correctly and running out of capital. This type of strategy requires careful planning and professional advice.
- Accept higher levels of risk by moving out the yield curve and buying lower quality assets. If this strategy is used we strongly recommend significant diversity in the portfolio and that it only be used for a portion of the portfolio. Again, planning and professional advice are key.
- Retire later if possible and look for some form of income generating activity in retirement.
- Use a combination of the above.