Liquidity vs investing

Risk aversion is innate - but what risk are you most averse to?

The impulse to protect what we have is instinctive to us all. Aversion to risk is innate, passed down from our hunter-gatherer forbears. Our ancestor who assumed that all rustling bushes concealed lions, lived long enough to pass that trait on. His more blasé counterpart exited the gene pool. Hence we are predisposed to over-weight the negative. Even when presented with a favourable proposition, we will generally avoid it if there is the potential for significant downside.

There’s nothing new in this - the tale is immemorial. But in the context of the interest rate and inflation outlook, the implications of this behavioural quirk for investment decision-making have taken on even greater importance.

With short-term interest rates in Europe at their highest level in over twenty years, it is easy to ignore alternative options to liquidity and default to short-term cash rates. If you can get 4% (in EUR) with negligible risk of capital loss, the incentive to move beyond liquidity solutions looks feeble.

Two questions arise. What if today’s short-term rates are a mirage? And what if the risk you are managing is not the correct one?

On the first question, I’m not certain, as there are many paths the global economy could take in 2024; no recession, mild recession, deep recession or even stagflation. Short-term rates may stay high in some of these scenarios. But our base case is that we have reached the peak of the hiking cycle and rates are more likely to be cut in 2024 than to stay elevated.

In a mild recession, interest rates eventually bite and inflation is nudged back towards target. In this scenario, the attractive short-term rates available today will no longer be available in a year's time, as central banks, convinced that their work is done, finally start to cut rates. Sitting with large cash allocations therefore entails significant reinvestment risk. We would expect core bonds to outperform in this scenario.

In a soft-landing scenario, where economies prove more resilient than we expect and inflation continues to abate, cash may be a better option than government bonds, with central banks not needing to deliver on the interest rate cuts that are currently priced in. But in this scenario, the stock market would likely welcome this outcome too.

I’m not ignoring the deep recession and stagflation scenarios. They are possible, just not probable. In either of the above scenarios bonds and stocks, or a combination, look preferable.

To the question – what if the risk we are managing is the incorrect one – I’m more certain. I’ve little doubt, but for a small minority, this is true.

Warren Buffett once described investing as “forgoing consumption now in order to have the ability to consume more at a later date.” The measure of risk implicit in this definition is inflation. If you are an investor, this is your appropriate measure of risk. If you accept this proposition, this likely upends what your gut tells you constitutes low and high risk.

For most people, the risk we are averse to is capital loss (usually short term) and the variability in the value of our principal.

If my living costs double (through rising prices) and my capital and interest thereon remain the same (on overnight deposit), I have effectively lost half my money. This should trigger alarm bells for the risk-averse. But we tend not to think about inflation risk in the same way as we do about the risk of capital loss associated with stock market investments.

My thesis on this is that we are concerned about the risks of doing something (making an investment decision), but not concerned about the risks of what we would perceive as doing nothing (defaulting to leaving money in cash).

In truth, I’ve no idea whether inflation will continue to abate in 2024 or whether it remains sticky at levels above Central Bank targets. The decade or so in which inflation undershot Central Bank targets looks more like an aberration than some new paradigm, so I think it makes sense to plan for a future in which it’s much more meaningful than we have been used to recently. In that scenario, it makes sense to adjust what you consider to be low and high risk.

Money market and short-duration bond funds are great in a rising rate environment. But 2024 will require a more active decision in relation to your cash. For long-term investors, you need to consider the possibility that short-term rates may not last much longer. But also consider the possibility that risk is more than just short-term capital loss and volatility.

We should all be averse to losing our capital – but it’s important that we measure that over the long term and measure it in real terms.