By LARRY SWEDROE
In his wonderful book Your Money and Your Brain, Jason Zweig showed the results of a study that asked more than 400 doctors whether they would prefer radiation or surgery if they became cancer patients themselves. Among the physicians who were informed that 10 per cent would die from surgery, 50 per cent said they would prefer radiation. Among those who were told that 90 per cent would survive surgery, only 16 per cent chose radiation. Clearly, the two choices are identical. Yet, highly intelligent, trained medical professionals allowed how the problem was framed to influence their decision.
Given that even highly trained medical professionals make mistakes caused by framing, should we not expect that individuals, most of whom are not highly trained in finance, would make the same type of mistake when it comes to investing? Chen Lian, Yueran Ma and Carmen Wang sought to answer that question in their study Low Interest Rates and Risk Taking: Evidence from Individual Investment Decisions, which was published in the June 2019 issue of the Review of Financial Studies. Specifically, they tested whether low interest rates — the environment we have been in since the financial crisis began in 2007, as central banks around the globe set benchmark interest rates to historic lows — impacted investor appetite for risk taking.
To find the answer, they set up two test groups (from a diverse group of US investors who were more highly educated than the general public) who were asked to consider between investing in a risk-free asset and one with a risk premium of 5 per cent and volatility of 18 (about the historical volatility of the US stock market), and an assumption that returns are approximately normally distributed. The only difference was that Group 1 participants considered investing between a risk-free asset with 5 per cent returns and a risky asset with 10 per cent average returns, while Group 2 participants considered investing between a risk-free asset with 1 per cent returns and a risky asset with 6 per cent average returns. Participants were randomly assigned to one of the two conditions. In both groups the risky investments have the same risk-adjusted expected return (the same Sharpe ratio). Therefore, as was the case in the study with doctors facing a decision on choosing between surgery and radiation, there should be no preference. Following is a summary of their findings:
- People in the low interest rate condition (Group 2) invest significantly more in the risky asset than people in the high interest rate condition (Group 1). However, people do not reach for yield when interest rates approach the historically high end.
- The mean allocation to the risky asset is 78 per cent when the risk-free rate is -1 percent, 70 per cent when the risk-free rate is 0 percent, 65 per cent when the risk-free rate is 1 percent, and 58 per cent when the risk-free rate is 3 percent. As interest rates rise further, allocations change more slowly. The allocation to the risky asset declines to 50 per cent when the risk-free rate is 10 percent, and stays about the same when the risk-free rate is 15 percent. The differences were statistically significant at the 5 per cent confidence level.
- The findings hold among large and diverse groups of participants—reaching for yield in low rate environments did not decline with wealth, investment experience or education, nor did it decline with work experience in finance among MBAs.
Lian, Ma and Wang noted that their results were consistent with the findings from an August 2017 study by the Dutch Authority for the Financial Markets on 900 Dutch households.
The authors provide two potential explanations for this behaviour. First, people may form reference points of investment returns. When interest rates fall below the reference level, people experience discomfort and become more willing to invest in risky assets to seek higher returns. The reference point can be shaped by what people become used to over past experiences. The observation connects to the popular view among investors that 1 per cent interest rates are “too low” compared to what they are accustomed to. They cited various papers in the literature demonstrating this behaviour. They found the reference influence in their results as those “who consider the high rate condition first (their reference point), have particularly high allocations to the risky asset in the low rate condition.”
The second possible explanation is that reaching for yield could be affected by the salience of the higher average returns on the risky asset in different interest rate environments. Specifically, 6 per cent average returns relative to 1 per cent risk-free returns may appear more attractive than 10 per cent average returns relative to 5 per cent risk-free returns. For example, people tend to evaluate stimuli by proportions (i.e., 6/1 is much larger than 10/5) rather than differences.
The authors set up tests across various interest rate environments and found that reaching for yield is particularly pronounced as interest rates decrease below historical norms prior to the Great Recession and dissipates when interest rates are sufficiently high. They concluded that “The patterns are consistent with history-dependent reference points.” They added that their findings are “also broadly consistent with salience, as the proportions change more with interest rates when rates are low.”
In an interesting experiment, they also tested whether taking risk decreases and reaching for yield dampens if investment payoffs are presented using gross returns (e.g., instead of saying 6 per cent, we say that one gets 1.06 units for every unit invested). In this case, the proportion of average returns shrinks (from 6/1 and 10/5 to 1.06/1.01 and 1.10/1.05), especially in the low interest rate condition, and becomes similar across the two conditions. As the higher average returns of the risky asset become much less salient, risk taking in the low interest rate condition diminishes. Clearly, how a decision choice is framed matters even when it shouldn’t—psychological mechanisms are at work that can cause investors to take more risk than they should, or would if they had a complete understanding of the issues. To test if their experimental findings held up in the real world, they examined portfolio allocations data reported by members of the American Association of Individual Investors (AAII) since late 1987. They found that allocations to stocks decrease with interest rates and allocations to safe interest-bearing assets increase with interest rates, controlling for proxies of returns and risks in the stock market and general economic conditions. The magnitude is close to what they found in their benchmark experiment. For example, a “one percentage point decrease in interest rates is associated with a roughly 1.4 to 2 percentage points increase in allocations to stocks and a similar size fall in allocations to ‘cash’. In their benchmark experiments, the treatment is a 4 percentage point difference in the level of interest rates, which is associated with a roughly 8 percentage point change in the mean allocation to the risky asset.” They also examined data on flows into equity and high-yield corporate bond mutual funds, and found higher inflows when interest rates fall.
Interestingly, just as was the case with doctors, increased sophistication did not help individuals avoid the framing mistake. The authors found that “reaching for yield is significant among financially well-educated individuals like Harvard Business School MBAs (a large percentage of which work in financial institutions), and does not appear to diminish with wealth, investment experience, or work experience in finance.”
These findings have important implications for both policymakers and investors.
During periods of economic stress, such as the financial crisis that began in 2007, fearful investors tend to seek the safety of Treasury bonds (as well as government agency bonds and FDIC-insured CDs). When they do so, they forego the risk premiums available from non-Treasury debt and equity investments. By driving interest rates down, increasing the “price” of avoiding risk, we see that the Federal Reserve’s actions lead many investors to increase risk taking. This behaviour helps boost capital markets and stimulate the economy (through a wealth effect), functioning as an additional transmission mechanism of monetary policy. That’s the positive side of the story.
The negative side is that it also leads many individuals to increase their risk taking, possibly exceeding their ability, willingness and/or need to take risk. This is especially true of individuals who take a cash flow (as opposed to total return) approach to investing (spending only from dividends and interest). Such investors can frantically search for higher yields. Purveyors of investment products are well aware of the behaviours and exploit them in their marketing, nudging investors to take on more risk than they should.
Higher bond yields can be achieved in two ways. The first is to take incremental maturity risk, which would increase the volatility of the portfolio and subject you to increased risk of unexpected inflation. The second is to take incremental credit risk. Another way to increase yield is in equity investments (such as stocks with a high dividend yield), real estate investment trusts (REITs) and master limited partnerships (MLPs). This route was the one chosen by many in the post-2007 period. All three strategies are in conflict with the main role of fixed income assets in portfolios—to reduce the overall level of portfolio risk to an acceptable level, allowing you to hold the amount of equities that is appropriate given your ability, willingness and need to take risk. Therefore, fixed income instruments should be limited to only those of the highest investment grade.
Another negative is, just as the herd piles into riskier investments in low yield environments, they can all rush for the exits when rates rise. This in-and-out behavior can contribute to financial instability.
Markets provide lessons; investors fail to learn
Spanish philosopher George Santayana famously proclaimed, “Those who cannot remember the past are condemned to repeat it.” Unfortunately, far too many investors have short memories, forgetting the lessons the market has repeatedly provided, and as recently as 2008: investing in risky high-yield assets works until it doesn’t! It stops working when equity markets fall, exactly when the safety of high-quality bonds is needed most. Investors in such “alternative” fixed income investments, such as high-yield bonds, convertible bonds, emerging market bonds, preferred stocks, MLPs and stocks with high dividend yields all suffered large losses in 2008. A few municipal bond funds even lost over 40 per cent in 2008, including Oppenheimer Rochester High Yield Municipal Fund (ORNAX), which lost 48.9 percent. Oppenheimer Total Return Bond Fund (OPIGX), which investors presumably used as a core bond holding, lost nearly 36 percent. And that return looks great compared to the loss of more than 78 per cent for Oppenheimer’s high-yield Champion Income Fund (OPCHX).
Investors that stretched for yield paid a severe price. The following are other examples of the returns to higher yielding investments in 2008: Vanguard Real Estate Index Fund ETF (VNQ) lost 37.0 percent; Vanguard Convertible Securities Fund (VCVSX) lost 29.8 percent; Vanguard High Dividend Yield Index Fund (VHDYX) lost 32.5 percent; JPMorgan Emerging Markets Debt Fund (JEDAX) lost 29.0 percent; MLPs lost 36.9 percent; and the iShares US Preferred Stock ETF (PFF) lost 23.9 percent. While all these risky investments were experiencing large losses, Vanguard Intermediate-Term Treasury Fund (VFITX) returned 13.3 per cent and Baird Quality Intermediate Municipal Bond Fund Class (BMBIX) returned 6.4 percent. While these high-quality fixed income assets were helping to dampen the losses created by a portfolio’s equity holdings, the other risky assets were contributing to the problem. In addition, investors in high-quality assets were able to rebalance, selling some of their high-quality bond holdings at higher prices in order to buy riskier assets at lower prices (and then benefited more from their eventual rebound).
Investors should learn two lessons from the experience of 2008. The first is to never confuse yield with return. The second is that credit risk is correlated to equity risk — when the risks to equities show up, credit risk tends to rear its ugly head at the same time. Thus, credit risk and equity risk don’t mix well together in a portfolio. That is why I recommend limiting fixed income investments to only Treasuries, government agency debt, FDIC-insured CDs and the highest investment grade municipal bonds (AAA/AA that are general obligation or essential service revenue bonds). However, if you are going to take corporate credit risk, limit it to only high investment grade and short-term bonds. Investors that did so at least avoided the severe losses many experienced in 2008.
Investors have now experienced the longest bull market for US stocks. At some point, it’s likely to come to an end. With that in mind, if you made the past mistake of stretching for yield because safe investments offered low returns that did not allow you to meet your spending objectives or needs, remember that, while even smart people make mistakes, they don’t repeat them. Using a total return approach, which I recommend instead of a cash flow approach, can help you avoid the mistake of stretching for yield. It’s also the approach that Vanguard’s Investment Counselling & Research team recommended in their 2007 paper Spending From a Portfolio: Implications from a Total-Return Approach Versus an Income Approach for Taxable Investors.
And finally, for those who have benefited from taking on more risk due to low rates, don’t make the mistake of “resulting”. Just because you earned higher returns doesn’t mean the strategy was the right one. Author Nassim Nicholas Taleb, author of Fooled by Randomness, provided this insight into the right way to think about outcomes: “One cannot judge a performance in any given field by the results, but by the costs of the alternative (i.e., if history played out in a different way). Such substitute courses of events are called alternative histories. Clearly the quality of a decision cannot be solely judged based on its outcome, but such a point seems to be voiced only by people who fail (those who succeed attribute their success to the quality of their decision).” In other words, don’t confuse a lucky outcome with a good strategy. The next time might be different. Be thankful the risks did not show up, and correct the mistake.
LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of 17 books on investing, including Think, Act, and Invest Like Warren Buffett.
Larry is a regular contributor to TEBI. Here are some of his other recent articles: