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Are investors burying their head to risks?

01st October, 2019

The 1980’s film Brewster’s millions sees the main character seeking to burn through $30m in a month with the proviso of having nothing to show for it at the end. If set the same task today, he may well consider a deposit in a Danish bank, which have been charging depositors for some time (accepting that this would not ‘blow’ all his capital). Given the recent European Central Bank decision to further cut its deposit interest rate, Irish banks may well follow suit (they’ve been charging corporate clients for a while now). 

Investing, Warren Buffett once described as “The transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power in the future”. Earning a negative rate on deposit all but guarantees a future with less purchasing power - barring deflation.

 

Being paid to borrow

Whilst you try to wrap your brain around being charged by your bank for a deposit, consider the possibility of you charging your bank for a loan. Governments have been borrowing money for years and been paid for the pleasure, but the idea that a homeowner might enjoy the same privilege would seem to be utopian fantasy. In fact, a Danish bank, Jyske, recently became the first to offer a 10-year home loan fixed at minus 0.5 per cent per annum. (Source: Jyske Bank and Rickard Milne, Financial Times article ‘Jyske becomes first Danish bank to impose negative deposit rates’ dated 20th August 2019’)
 
Negative interest rates – whether on loans or deposits - upend so many tenets of capital markets that it leaves me with more questions than it does answers. 

There are no playbooks for navigating a world awash with negative-yielding government debt and bank deposits. But in witnessing the habits of investors over the past twelve months, zero interest on cash seems to be having an unsettling impact on the investment choice of some.

It’s natural that in a low yield environment, investors might loosen their investment criteria in the search for return. But risks are either being overlooked or more likely, misjudged.

 

Judging risk by recent outcomes

A financial adviser recently delighted in telling me that his clients earned a 30% return over three years in a product. On reinvesting the proceeds into the next tranche of the same investment he rhetorically asked, “sure where else would you get it?”.

I can’t think of anywhere else you’d get it, to be frank. The supposition to his question was that it was achieved with little risk. But a glance at the prospectus would reveal otherwise.

I won’t go into detail in relation to the specifics of this product. I tried to explain the risks to him, a task complicated by the strong return achieved. Nothing sedates critical thinking quite as much as effortless profit (or the appearance of). Some weeks later, a useful analogy occurred to me. 

Siegfried & Roy are a German-American duo of magicians and entertainers, who became known for their appearances with white lions and tigers. From 1990, until 2003 the duo performed at the Mirage Casino, in a stage show that was regarded at the time as the most successful in the history of Las Vegas. The show was abruptly cancelled in October 2003 after Roy sustained life threatening injuries after being mauled by one of the lions. 

A financial analyst observing the show a month prior to its cancellation, might have concluded that it was extremely low risk, as it had a thirteen-year history without notable incident. Any savvy observer without such a narrow view would have reasoned otherwise.

I’ve no idea whether the product referred to earlier will have an ignominious end. But what I am sure of is that the lazy assessment of risks through the narrow prism of recent outcomes is doomed, at the very least, to deliver a major surprise eventually. 

 

Where’s the pot of gold?

Smart investing involves bearing risk when well paid to do so. It doesn’t involve burying your head to the risk.

I understand the imperative to achieve a return in this low yield environment. Cash paying little or no return may seem painful in the calm investing seas we have sailed through in the past decade. But the certainty of no return on your capital, should always trump the possibility of no return of your capital, so buyer beware.

Spoiler alert - Brewster ends up inheriting the $300m at the end of the eponymous movie. There’s no pot of gold at the end of the rainbow for investors. You need a finely tuned rubbish radar that screams red alert when promises of abnormal returns without abnormal sacrifice are offered. Or a good impartial adviser (who cannot guarantee a return but should be able to advise).

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