Escaping the Trap of Low Interest Rates and Equity Risk Aversion: Two Problems and Two Solutions
Investors with a long time horizon can use behavioral finance tools to maintain significant equity exposure, avoid risk aversion, and generate attractive risk-adjusted returns.
It’s been a strange year for society, the economy, and the markets, but one thing is clear: Investors will start to think about what’s ahead. The gut-wrenching volatility of 2020 may lead some investors to pull back on risky securities, such as stocks, as they do annual reviews of financial plans and measure progress toward long-term goals. Unfortunately, many decision-makers in this situation face financial and emotional constraints that may feel like a catch-22 as they consider asset allocation changes. Low interest rates are reducing the attractiveness of bonds, while risk aversion is pushing many investors away from stocks.
Fortunately, investors with a long time horizon can break free from these problems by using behavioral finance tools to maintain significant equity exposure, avoid risk aversion and generate attractive risk-adjusted returns. Let’s explore these problems and dig into some behavioral finance solutions.
Problem #1: Inflation is Eroding Bond Returns
Interest rates were historically low heading into the COVID-19 pandemic, and emergency Fed rate cuts in spring 2020 brought nominal levels to just above zero. However, inflation continues to run between 1.5% and 2%, eroding the value of safe, government bond returns. For example, ten-year Treasury bonds are currently yielding just under 1%, suggesting that the real, inflation-adjusted return for these bonds could be negative for a decade. Investors looking for safe returns face a dilemma: Lose money by owning Treasuries or abandon safe bonds in search of greater returns elsewhere.
Problem #2: Risk Aversion May Push Investors Away From Equities
This brings us to a second problem facing investors looking to rebalance their portfolios: risk aversion. We just learned that investors may lose money by purchasing safe government bonds, but now many investors may be reeling from equity market volatility this year and feeling cautious about buying stocks. The rapid-fire bear and bull markets in early 2020 may signal danger for some investors, leading to risk aversion, even though broader markets have generally recovered.
Risk-averse investors often feel that the pain of losses is about twice the joy experienced in similar-sized gains. This imbalance could lead investors to turn down an attractive gamble, such as buying stocks that could go up 20% or down 10%. As risk aversion grips many investors, they may stumble into poor asset allocation decisions, such as having too much exposure to bonds or cash.
Solution #1: Make Your Time Horizon Work for You
Now that we’re all tied up in knots with our asset allocation decision, let’s take a deep breath and see if we can find a way out.
One solution to this tricky situation is to consider your time horizon. If your financial plan extends for at least a decade, historical trends may give you greater comfort with your asset allocation review. Why is a decade important? Risky asset classes can lose money in the short term, but losses become rare over longer periods of about a decade. Even in the extreme case of going from 100% cash to 100% stocks right at the top of the dot-com bubble in 2000, stocks finally recovered from two recessions by 2011. In most cases, stocks recover from bear markets in just over four years and most investors avoid all or nothing decisions, such as moving completely in or out of equities. The bottom line here is, time is on your side, even for risky assets, and especially if you are looking at a decade or more.
Solution #2: Break Free From Equity Risk Aversion
A longer time horizon can get us more comfortable with owning equities, but let’s go deeper to see if we can further reduce our aversion to equity-related risk. Investors often have a bias to remember recent events rather than all events, and the 34% drop in the S&P 500 in February and March 2020 is a vivid example of this recency bias. Fears of another sharp drop could lead investors to favor bonds, which might actually be more dangerous for long-term returns than equities.
Since 1928, the S&P 500 has generated total returns of about 11% per year, with a standard deviation of about 19%, according to Bloomberg. In plain English, stocks usually go up about 11% a year, but there are plenty of up 30% and down 10% years. Even if stocks only go up 5% per year in the future, it sure beats the heck out of zero or negative returns in government bonds.
Push Back Against Risk Aversion and Use Stocks to Offset Inflation
We’ve made the case that the odds are in your favor for using stocks to offset inflation, especially if you have at least a ten-year time horizon. However, you may need some motivation to take on stock volatility more confidently and still sleep at night. Here are a few behavioral finance concepts that you can lean on in trying to get comfortable with long-term equity risk.
Practice self-control: Remove behavioral cues that can get you in trouble, such as fixating on recent performance. Turn off your quote screen or look at your statements less frequently as a way to take the high road on equity volatility.
Use broad framing: Move away from a narrow frame such as a binary choice between cash and risky stocks. Broaden out your frame to a focus on time horizon, long-term goals, and the kind of returns you need to offset inflation and meet these goals. Within this broader frame, a greater allocation to stocks can be one part of the puzzle that helps you achieve your goals.
Avoid status quo bias: Many people feel more regret for action than inaction. Break out of this inertia by reminding yourself of the powerful combination of equity returns and a long time horizon in a battle against inflation.
Win a few, lose a few: Markets may remain volatile after your asset allocation decision. However, take comfort in a more holistic view of gains in your own past performance and the long-term prospects for equities to more than offset inflation.
These concepts can help you use equity risk as an advantage, especially if you have a time horizon that stretches a decade or more.
About the author: Mike Bailey, CFA®
Mike Bailey, CFA®, is Director of Research at FBB Capital Partners in Bethesda, Maryland. In determining investments for client portfolios, he monitors and analyzes economic data as well as secular industry trends. Mike is also the chair of the Investment Committee at FBB Capital Partners and a member of the CFA Society of Washington, DC. Among his areas of expertise are security selection, asset allocation and risk management.