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Are there any positives with negative interest rates?

31st August, 2020

Published in the Sunday Times on 30th August, 2020
A recent cartoon drawing caught my eye. A customs officer checking a passengers luggage, admonishes him for having a plastic straw - hidden in his bag of cocaine! I was reminded of this recently with the media coverage of the disquiet over the recent decision by banks to start charging for deposits from its pension and corporate clients. The concern is more appropriately directed at the enormity of cash allocations in portfolios, rather than the impending charge.

The impulse to protect what we have is instinctive in us all. This applies to all manner of possessions, not least our wealth. The application of negative interest rates on deposit has understandably struck a chord. But it’s possible this may be a force for good, if it’s the call to action that triggers investors to confront a decision they have been unwilling to make.

Confusing certainty for security

All investors should have immediate liquidity requirements addressed as part of their financial plan. So there are legitimate reasons for holding cash in a portfolio. But to the extent that there are holdings beyond requirements for short term expenses, the reasons provided are generally a variant on a constant ‘safety’ or ‘peace of mind’ theme. But I think this is confusing certainty for security.

  • Certainty – is defined as a fact about which there is no doubt or something that you know will happen in a particular way. Does cash provide certainty? Unequivocally yes. We are certain about the direction of deposit interest rates and that cash holdings will be negatively impacted.
  • Security - the state of being free from danger or threat. Does cash provide security? Unequivocally, no. The certainty of cash does not provide security against the real risk that investors face. And that risk is the real value of savings – the primary threat to which is inflation.

Defining risk as loss of purchasing power

We tend to think about money in nominal terms – euros and cents in our bank account. In the long run, the only rational definition of money is purchasing power. If my living costs double and my capital and interest thereon remain the same, I have effectively lost half my money.  If money is purchasing power, risk becomes that which threatens it and security, that which preserves or enhances it.

And this is the critical issue. We have grown up with the idea (misguided) that the primary risk of investing is the variability of our capital over short time horizons. Defined as such, then cash does seem low risk. Afterall, even with negative interest rates we can be fairly certain of what the value of a deposit will be six or twelve months from now.

Defining risk, not as volatility, but as loss of purchasing power, changes the investment landscape completely. What is traditionally defined as low risk, cash and bonds, becomes high risk in this context (as they have historically provided minimal security from inflation). The assets that have protected us from long term real losses, (e.g. equities, real assets) are low risk in this context.

But as Abe Lincoln once mused, calling a dog’s tail a leg, doesn’t make it one. Similarly, defining investment risk as the loss of purchasing power, doesn’t necessarily change how people view risk.

Successful investing means having to deal with uncertainty

Arguably the most important aspect of what it means to invest successfully is getting investors to stay the course through the inevitable ups and downs along the journey. However much I might argue that volatility is a misguided measure of risk, in the main, investors do not like volatility and are averse in the extreme to multiple periods of negative returns.

Defining risk as loss of purchasing power with its attendant implications for investment strategy, may be setting investors up for expensive failure. But it behoves good advisers to help clients distinguish between short term uncertainty and long-term security.

Uncertainty - the condition of observing something that may or may not happen, or whose outcome we don’t yet know - is the only constant in investing. And investors— who are deploying their capital for some future use—must bear that uncertainty in their decision-making.

Don’t seek certainty, seek good advice

To return to the start – the issue of pending negative rates on deposit is not the story here. The real story is why there are such large cash balances in banks, which I’ve argued is a symptom of a misguided sense of risk.

The default position of holding cash has always extracted a price in the form of opportunity cost. Now that decision is about to attract an explicit cost in the form of negative interest rates. Use this occasion to at least ask two questions; why am I holding cash and is the loss of purchasing power a more important risk metric than volatility.

If you have a genuinely long horizon with liquidity needs that are satisfied, and chose to manage uncertainty through holding cash, you are trying to slay the wrong dragon (volatility). There are many firms that will provide you with the certainty you seek. But if it is long-term security you need, then the foregoing has implications for you. Don’t seek certainty. Seek good advice. 

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