22 July 2020
The new world of low investment returns
The world has changed. In March 2020 we faced the worst economic crisis since the Great Depression. Share prices plummeted. In response to this, central banks took unprecedented action, pumping large amounts of money into markets causing share prices to rise again. Some say shares are now over-valued and could quickly fall if investors become nervous about economic or political events. Meanwhile, interest rates are at record lows.
We have seen such huge structural changes to global financial markets that it is now difficult to determine what ‘normal’ market behaviour is. We have low global economic growth, low interest rates, and highly volatile share markets. In historical terms, this is extremely unusual, and it is hard to predict what will happen next. Signs are that the current conditions could continue for a very long time. We are in a world of low investment returns and we need to adjust our thinking accordingly.
When returns are low, there is always the temptation to take on additional risk to get a higher return. It’s easy to take on more risk when things are going well and the possibility of loss seems remote. But this is not a particularly wise strategy if the risk puts you in danger of losing more than you can afford or could cause you emotional stress.
It is not all bad news for investors though. The key measure of long-term investment performance is the return after tax and inflation. While investment returns are low, so is the rate of inflation. Historically, high interest rates have been accompanied by high inflation which has reduced the real rate of return (interest rate less inflation rate). However, some economists are picking that the next cycle could be one of high inflation, caused by the massive amount of government money being pumped into circulation.
There are various tactics that can be used to increase return without necessarily increasing risk. While volatility is here to stay, it can be used to your advantage. Successful investors use a drop in the market to invest more. There is no better time to buy than when prices are low. Far from being something to worry about, volatility is an essential ingredient for investment performance. Without it, there would be no capital gain.
Furthermore, just because returns in the share market as a whole are low it doesn’t mean there isn’t growth in particular sectors. There are always opportunities if you look in specific areas, such as emerging markets or technology-based industries. The trick is to find those sectors that are performing against the market trend.
A useful tip for reducing investment risk when first setting up a portfolio is to invest in frequent, small amounts over a period of several months. This means that funds will be invested at various points in the market cycle, rather than investing in one lump sum and taking the risk of what prices will be on a single day.
In markets such as we have now, passive funds may perform less well than actively managed ones where fund managers are seeking shares that are outperforming the market. Short term tactics are needed to take advantage of opportunities. A flexible approach to asset allocation is required to be able to respond quickly to changes in market conditions.
If all else fails, it may be necessary to adjust your planning to take account of lower returns. Goals may take longer to achieve, or retirement may need to be delayed. For retirees, lower returns may mean adjusting spending to a lower level of income or running down capital to top up income.
With such low investment returns, the days of living on the income from an investment portfolio while maintaining the capital are over. The key issues for retirees are how to make sure money is available when it is needed, and how to invest it for a reasonable return with an acceptable level of risk until such time as it is spent.
Achieving good returns when markets are doing well requires very little effort. The next few years won’t be so easy and successful investors will be those who adjust their thinking to the new environment and put in the hard work to find opportunities while managing risk.