How To Invest During Low Rates
Navigating investments in a low-return environment
|Written by Tom Yeung, CFA | CDFA
Investment Advisor & Fund Manager, Jurnex Financial Advisors
Over the past decade, Americans have faced an increasingly worrisome problem:
How to invest in a low-interest-rate environment?
Low rates → low returns
As US bonds rates have fallen to record low yields, it’s become harder for both younger and older savers alike to ensure they wouldn’t outlive their retirement funds. Investors have found themselves taking more risks in stocks and real estate.
Yet, stocks and real estate returns can’t remain high forever either. Prolonged periods of low bond yields tend to depress returns of other assets too. So how to invest for retirement when expected returns aren’t as high?
In this article, we’ll cover: how to invest when interest rates remain low.
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Why do low rates matter?
In his seminal 2013 book Capital in the Twenty-First Century, Thomas Piketty, a French Economist, proposed that our modern monetary system rests on one essential observation:
Investment rate of return > growth rate
In other words, “r > g.”
In the Western world, the rate of return of investments for the past 250 years has been higher than the rate of economic growth. While this caused problems of inequality and wealth concentration at the top, it also meant that savers who accumulated capital saw their savings grow faster over time. Otherwise, the passage of time would have eroded the value of any investment.
“r > g” makes saving money worthwhile
Having a nest egg that grew faster than economic growth meant one thing became possible: a long retirement. That’s because retirees suddenly found themselves able to live off their nest egg’s interest alone. And even those who didn’t save enough could still draw down the principal at slower rates.
The system became the core tenant of investing in the 20th century: savers could put money in the stock market, and compound interest would grow their savings FASTER than economic or inflationary growth. Defined benefit plans, 401(k) plans, and home equity could thus all accumulate wealth for their owners.
What happens when r is LESS than g?
As rates of return dip below growth rates, savings can suddenly become worth LESS over time.
In other words, saving for retirement becomes like filling a leaking bucket: no matter how much you add in, the relative value of the principal shrinks over time.
Nest egg investments grow slower (or can shrink!)
Over the past decade, the expected rate of return on investments has collapsed. Despite ever-higher stock market prices, corporate earnings have lagged. The cyclically adjusted price-to-equity ratio (CAPE) of the S&P 500, a signifier of market value, is now at 32 times. That means even if companies were to distribute 100% of their earnings, the cyclically-adjusted dividend yield rate would only reach 3.0%.
Low rates pose an enormous issue for savers. No longer can savers add to their nest egg and expect it to grow. So how to invest in this new rate environment?
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How To Invest During Low Rates
Five tips for getting more out of your savings
1. Invest Abroad
A 2019 assessment by the National Bureau of Economic Research found that, on average, US investors hold just 10% of their stock investments in foreign companies.
In comparison, US stocks represent 49% of the total world equity market.
American investors who look further afield will find far cheaper markets, as represented by lower CAPE ratios. (Lower CAPE ratios means higher earnings yields)
- Developed Markets. Countries such as Canada (23.7x), Japan (21.2x), Australia (17.9x), and UK (15.8x) have far lower CAPE ratios than the US (32.0x).
- Emerging Markets. China (15.7x), Korea (12.5x), and Russia (9.7x) have lower CAPE ratios than their developed-market counterparts. Emerging markets may have risk, but also higher return potential.
- Frontier Markets. While more challenging to invest in, frontier markets such as Vietnam, Nigeria, and Jordan provide additional diversification for investors looking for higher returns.
Often, investing abroad requires the use of specialized funds or professional investment advisors.
Yet navigating foreign investments is one of the few key places that we have left in achieving supernormal returns in a low rate environment.
2. Use Leverage
As the rates of returns have decreased over time, many investors have turned to mortgages and other loans to help maintain profits.
Used correctly, leverage in controlled quantities can help investors generate a higher return without adding too much risk. In particular, owners of multifamily real estate have generally seen excellent risk-adjusted gains over the past decade.
Corporations have also leveraged up
Companies too, have been leveraging up. In 2010, the average nonfinancial US company had a debt to net worth ratio of 0.66x. In other words, companies borrowed 66 cents for every dollar of equity invested. in 3Q19, that ratio had skyrocketed to 1.25x. Increased borrowings have boosted profit margins from 9.0% in 2010 to 11.8% today.
However, beware of borrowing too much. As shown in the 2008-2009 housing crisis, over-leveraged homeowners can quickly become overwhelmed by debt if they’re unable to meet monthly payments. Keeping a 6-8 month cash reserve is essential for any landlord.
3. Optimize taxes
Investing in a low-rate climate can be summed up by the Serenity Prayer, written by American theologian Reinhold Niebuhr:
God, grant me the serenity to accept the things I cannot change,
Courage to change the things I can,
And wisdom to know the difference.
That’s because savers need to focus on the things they CAN change.
That’s because there’s one guaranteed way to boost free cash flow that’s 100% under your control: reduce taxes.
- Tax-Advantaged Accounts. Using 401(k), IRA, and 529 college savings plans can guarantee an immediate return on investment by eliminating capital gains taxes.
- Tax Planning. Pre-planning gift and estate taxes can help shield assets from the federal 40% estate tax.
- Business Deductions. Deducting business expenses can significantly reduce taxpayer’s taxable income by 20% or more, thanks to changes in the 2018 Tax Cuts and Jobs Act (TCJA)
The US tax code has become far more complicated over time. Legacy deductions and write-offs tend to compound with each tax-law update. It’s no surprise that the corporate flat tax rate of 21% is rarely ever paid. (Instead, the average US Corporation pays about 12% in federal income tax)
Tax breaks aren’t just for the ultra-wealthy
Few wealthy people pay the top rate of 37%. On average, people making >$1 million pay just 29% of their income in taxes. Yet, most affluent people also have multiple options for using tax deductions, especially though self-employed business deductions.
Beware, however. Navigating these tax breaks requires knowledge of tax law to utilize loopholes without breaking IRS regulations. Offshore tax shelters, for example, are largely illegal, while qualified business deductions are perfectly legal.
4. Save More Money
When investing in low-return environments, investors need to raise their savings rates.
Failure to update expectations is a widespread problem. For example, the CFP Board, the organization responsible for certifying financial planners, has long maintained that savers should target a 10% savings rate. However, when long-term returns are only 3-4%, a 10% savings rate only replaces 55% of income in retirement.
Today, the average saver looking to replace his or her full income in retirement would have to save 21.8% of their salary, before considering Social Security.
For most young people, saving 20% of income is an impossibility. Yet, until the rates of return improve, there’s little way for savers to fund a long retirement through investing alone.
5. Retire Later
In 2019, the French government, under President Emmanuel Macron, proposed a policy that was unthinkable just a decade ago: to raise the full retirement benefit age of France from 62 to 64. After six weeks of violent protests and strikes in the country, however, the government decided to withdraw the proposal.
Retirement age will increase over time
However, these propositions will become more and more common as people live longer and returns remain low. That’s because, as populations age, the elderly spending will comprise an increasing proportion of GDP. In 1990, there were about five working-age Frenchman for every retiree. In 2018, the number was closer to just three.
The US will see a similar issue over time. By 2050, the US Census Predicts that the number of Americans age 65 and older will double to 88.5 million.
As the dependency ratio worsens, more people will have to work past age 65 to maintain their lifestyle. That’s because public retirement benefits, such as Social Security and Medicare, will struggle to support the elderly with an ever-decreasing base of working-age people.
Investing in a low-return environment requires skill, patience, and controlled risk-taking. Savers who simply leave money in low-growth savings will find their assets decreasing in value over time. Over time, inflation can bring down the value of even the most conservatively invested portfolio.
That’s why it’s essential to invest smarter when interest rates are lower for longer.
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Where to find more resources
If this seems like a lot of information, don’t worry. The great news is that help is available. That’s because here at Jurnex, we work with individuals and families just like you to make the most out of investing. I’ve helped invest client money for over a decade in the same old-fashioned way. And that’s to seek out great companies in great industries that can you can buy at a discount to their fair value. Sounds too simple to be true? Give me a call today, and I’ll show you that it’s still possible after all these years.
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