Unconventional wisdom: Four assumptions for building wealth that investors should revisit

Morning Star AU

23 hours ago

Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. Each ...

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You follow it at your peril. 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You follow it at your peril. 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You follow it at your peril. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.Unconventional wisdom: Four assumptions for building wealth that investors should revisitThe supposition that the future resembles the past, is not founded on arguments of any kind, but is derived entirely from habit.- David HumeLast week the Reserve Bank raised the cash rate. The rate increase wasn’t a surprise and the resulting finger pointing was predictable and performative.As always, it is ordinary Australians who are left to face the twin challenge of persistently high inflation and rising mortgage payments. The focus on the cyclical interest rate environment is understandable. The direction of the next few interest rate moves will impact borrowing costs for businesses and consumers. But I want to focus on another question. Are we witnessing a structural shift in interest rate levels? If we are, the implications on building wealth will extend beyond the next RBA rate decision. I’ve come up with four things for investors to consider if we are at an economic turning point. But first a quick primer on structural interest rate cycles. Structural interest rate cyclesA structural interest rate cycle is a longer-term trend that can last decades. Within this macro environment cyclical interest rate cycles will continue to occur based on central bank policy. Focusing too much on these short-term gyrations can cause investors to miss the overall trend. This can particularly impact investment outcomes at an inflection point between two eras. This is where investors following yesterday’s playbook can run into trouble. Structural interest rate environments are influenced by forces that extend beyond central bank policy. These longer-term trends are easy to see in retrospect but harder to spot as they are occurring.Examples of longer-term trends that influence structural interest rate levels include meaningful demographic shifts, productivity changes and inflation levels. Most of us have lived and invested through a single structural interest rate environment. Between approximately 1980 and 2020 interest rates were in a structural decline. There were several interconnected drivers including workforce growth, globalisation and low inflation.Today there are lower numbers of working age adults, a pullback on globalisation and stubbornly high inflation. Rising bond yields are reflective of this environment along with increased borrowing. The funding for the AI infrastructure buildout is increasingly coming from the bond market and heavily indebted governments continue to borrow as entitlement and defence spending increases. Implications for investors in a sustained higher rate environmentInvestors have been conditioned by four decades of structural decline in interest rates. If that era is ending these are four assumptions worth revisiting. Does gearing your way to wealth still work?When interest rates are in a structural decline the formula for building wealth is simple - borrow money and invest it in growth assets. Older Australians have benefited from this formula even if it wasn’t an intentional strategy. According to Orange Finance fixed and variable rate mortgages were over 15% in 1990. As Australians gathered to watch the Sydney Olympics in 2000 mortgage rates had dropped to between 7% and 8%. Between 2014 and 2020 homeowners were paying less than 5%. Source: Orange FinancialNot only did homeowners benefit from lower mortgage payments but asset prices also rose substantially. Bonds, shares and real estate typically benefit from a structural decline in interest rates. This tailwind is not the only factor influencing asset prices, but it certainly helps. Things look different today. As many have pointed out the RBA cash rate is at a 15-year high after the recent hike. But adding the context of a longer-term view shows the current level of 4.60% sits slightly below the 4.70% average between 1990 and 2019. The extraordinarily low rates during the pandemic distort the view of ‘normal’ interest rates. To be clear, gearing will still amplify returns if asset prices grow faster than the cost of borrowing money. However, for homeowners or investors in geared ETFs the degree of amplification will fall if the differences between returns and borrowing costs are lower.When you combine this with the risk of taking on debt the case for gearing is less clear. In a different environment when the spread between returns and interest rates is smaller or turns negative, gearing could be an anchor holding back household wealth creation instead of a tailwind. Is cash still trash?Do you remember TINA? That was the in-vogue investing acronym during the early 2020s which stood for ‘there is no alternative’. The logic was simplistic but made a certain amount of sense. With interest rates close to zero there was no alternative but to invest as much as possible in shares.The opportunity cost for taking on more risk was low. Higher interest rates today provide more incentive to hold cash.Many people only think about nominal returns. Looking at real – or inflation adjusted – returns provides additional perspective. In September the average interest rate on a savings account is 4.87% according to BankMate. In isolation that looks good but the real return is still low considering the last inflation reading in August was 4%.But real returns for all asset classes drop in periods of high inflation. The following chart from Owens Analytics shows historical returns in different inflation environments. In rising inflation phases, rising inflation years and high and moderate inflation years the return differential between cash and growth assets shrinks. Compounding this shrinking risk premium for growth assets are the other advantages of cash. Cash provides liquidity and safety for investors and protection from volatility. The lesson is not to go completely defensive in a higher inflation / higher interest rate environment. You need growth to counteract the erosion of purchasing power. But don’t continue to ignore cash as it serves several purposes in relation to the holistic set of goals many investors are trying to achieve. Should you buy the ‘dip’ in bonds?Like cash, bonds become more attractive on a relative basis in a higher interest rate environment. There is currently a good deal of talk about how attractive bonds are. Current US 10-year Treasury yields are around 5.20% which is the highest level since 2002. For investors accustomed to investing in an environment with interest rates in a structural decline this is very attractive. But the problem with bonds is their prices move inversely to interest rates and unlike cash there are price movements to consider. If US Treasuries are yielding 7% in the next few years most individual investors will not be happy with their returns. I’ve observed a disconnect between how investors think about bonds and how they gain exposure to them. Most individual investors think of bonds in the same way they think of a term deposit. People look at the interest rate and assume that if they invest in safe bonds that is the return they will receive. That is true if you buy an individual bond. As long as the bond doesn’t default you will get your money back and your return is equal to the interest rate. The problem is that many individual investors are now buying bonds through passive ETFs.A passive bond ETF has no maturity when you get your money back. The price of the ETF will be driven by several factors but primarily is impacted by changes in interest rates. An example is illustrative. In October 2021 the yield on a 5-year Australian government bond was roughly 1%. If you bought the bond outright you would have earned 1% a year and gotten your money back this month. Things look different if you bought an ETF like the Vanguard Australian Government Bond ETF (ASX: VGB). This ETF tracks an index of bonds with a weighted average maturity of a little over 6 years. This is not precisely equivalent to my 5-year bond example but still illustrates my overall point.The annual return of the ETF over the last five years is -0.67%. As interest rates rose the prices of the bonds held by the ETF fell – just as they will fall if interest rates keep climbing. Considering inflation in Australia averaged 4.20% over the last five years the real return outcome was quite poor.The point is not that bond ETFs are inherently bad. Instead, it is a call to consider how you access bonds and the implications if interest rates keep climbing. Buying the bond dip only works if interest rates start to fall. The government / central bank will always come to the rescueWe’ve become accustomed to investing in a structurally low interest rate and inflation environment. In this environment governments and central banks are always available to rescue the economy…and investors. The response to any crisis has been similar. Central banks lower interest rates and flood the system with liquidity through measures like quantitative easing. Fiscal responses from governments add to the support of the economy. This policy response is more challenging in a high interest rate and inflation environment. Governments have less flexibility to provide fiscal stimulus because existing debt levels are more restrictive in higher interest rate environments. In 2024 the US government started paying more in interest payments than on defense spending for the first time since the 1920s. Since 2024 this gap has widened as interest rates have increased. Meanwhile, the dual mandate of central banks to support the economy and keep inflation in check ties the hands of policymakers. The increasing tension between central banks and politicians over interest rate policy is reflective of this environment. This isn’t a reason to stop investing. But it is a reason to think about the resilience of the assets you hold in your portfolio during a crisis. When governments and central banks have less tools to use when coming to the rescue their response might be less effective. Final thoughtsI shy away from sweeping pronouncements about what lies ahead. Everyone should retain the humility to respect the uncertainty of the future – especially investors. Yet history demonstrates there is a certain cyclicality to events. There is no hubris in suggesting that at some point we will enter a period of structurally higher interest rates. The danger for investors is falling into the trap of thinking that successful tactical responses to events from one era will work in another. Gearing is an effective strategy in a falling interest rate environment with strong asset price growth. In a rising interest rate environment with slower asset price growth it can lower living standards and limit flexibility. US 10-year Treasury yields of 5.20% look high in relation to the pandemic years. The perspective changes when considering 15.80% yields in September 1981. Governments will always be able to borrow more money. Until they can’t.Investing isn’t always about earning the highest returns. It is about building financial resiliency for a range of possible future scenarios. If we are entering an era of structurally higher interest rates don’t assume what worked in the past will work in the future. Quesitons, comments or restaurant recommendations? I can be reached at [email protected]Get your finances on track with Invest Your WayOur book Invest Your Way is available in 206 bookstores across Australia. Kindle and audiobook versions can also be purchased.Invest Your Way is a personal finance book that combines foundational investing theory, real-world application and our own experiences. It is designed to help readers create a financial plan and investing strategy that is tailored to their unique goals and circumstances.Purchase from AmazonPurchase from BooktopiaGet Mark’s insights in your inboxRead more of Mark’s articlesRead previous editions of Unconventional wisdomWhat I’ve been eatingGalatoire’s is the perfect embodiment of New Orleans. This palace of Creole cuisine on Bourbon Street is festive, slightly chaotic and steeped in history. And every dish I had was delicious. Veal sweetbreads with a lemon caper beurre blanc and seafood okra gumbo to start, followed by a grilled redfish covered in shrimp etouffée. But the highlight was the shrimp Creole. The word ‘Creole’ was originally used to describe people in the colonies with mixed European and African ancestry. The Europeans who originally settled in New Orleans were French and Spanish and Creole cuisine reflects this mix of culinary traditions along with those of African slaves and Caribbean migrants. Shrimp creole starts with the holy trinity of diced onion, green capsicum and celery and adds creole spices, Worcestershire sauce, Louisiana hot sauce and tomato sauce. It is a dish that works in any interest rate environment.","kind":"highlight","is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":false,"editions":null,"column":"","sentiment":"0","news_tag":"","news_rank":0,"isVideo":false,"video":null,"symbols":[],"gpt_button":0,"need_auth":false,"need_login_tip":false,"code":"91000000","status":"200"}}}