In this edition of the Loch Fyne Financial SmarterInsight™ series we look at the current market environment and the challenges for savers and investors. When you look back it was only in the mid-2000s that some investors were beginning to doubt whether owning an investment portfolio was really worth all the risk, given that they could get around 5 to 6% by placing cash on deposit with their local bank.
Today, things are very different. The yields on lending (placing deposits and owning bonds) have been driven to all-time lows, as the UK and other world governments dropped short-term interest rates and bought back bonds from financial institutions (quantitative easing) to try to stimulate the economy and help the indebted masses – individuals, companies and banks – out of a big hole.
The result has been a transfer of wealth from prudent savers to less prudent borrowers. For many retirees who supplement their pension income with interest from deposits, this has meant a dramatic fall in living standards.
The challenge for savers
Inflation shrinks the value of your savings over time. In fact, when you look at the numbers it is sobering to see that from 2009 to 2012 savers holding cash lost over 12% of the value of their purchasing power due to inflation.
The challenge for investors
For those who own long-term, well-structured investment portfolios the situation is a little different. Since the credit crisis began bond yields have been falling for a number of reasons such as the flight of investor money to safer investments, weak economic growth, reduction in the Bank of England’s base rate, a glut of global capital from cash-rich emerging economies and the impact of quantitative easing. That has been good for bond prices and short-dated bond returns have outstripped returns from deposits after inflation, however, while this has protected investors wealth, the challenge is that, today, bond yields stand at an all-time low.
If they stay where they are, then returns going forward will be low. If yields rise, then returns will be poor due to capital losses eating up, and very possibly exceeding, the income paid on the bonds.
What should investors do?
The temptation and danger is that investors go on a hunt for yield, scouring the investment world for investments that are delivering higher yields. This is a route often taken by more traditional advisers and investors who think in terms of ‘natural yield’ or the cash income that a portfolio produces by way of coupon payments from bonds and dividends from equities.
This can lead to investors exposing themselves to too much risk, by investing in high yield credit that acts in a similar way to equities, thereby reducing the diversification in their portfolio and potentially causing volatile fluctuations.
While there are no absolute right or wrong approaches to investing, there are certainly some solutions that are preferable to adopt. Chasing ‘natural yield’ tends to trade income today for the material downside risks.
A ‘total return’ approach, on the other hand, delivers an income to the investor from dividends and coupon payments and makes up any expenditure gap from capital. The main advantage of this approach is that it allows the portfolio to remain properly diversified, rather than becoming concentrated around credit risk in bonds and increasing sector and company specific risks in equities. The risk level of the portfolio is also maintained where it should be.
Sticking with a strong and flexible financial plan and a well-diversified portfolio is a better option than chasing higher yields, blind to the material risks that are taken on by doing so.
If you are concerned about your saving or investment strategy, we are happy to provide an impartial second opinion. Please contact a member of the Loch Fyne Financial team to arrange an obligation free exploratory meeting. If you would like to subscribe to the Loch Fyne Financial SmarterInsight™ series to receive our emails direct to your inbox, please get in touch.