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By Wealth Foundations

What to do when cash rates fall?

With interest rates on cash in Australia falling to record lows, in absolute terms, there seems to be a scramble by investors to chase higher returns for their capital. Cash, which often ends up as the investment of choice by default, seems no longer a palatable option, with cash rates at a level that is now causing significant pain for many investors.

With cash rates so low there are numerous alternatives that offer a higher income return, or yield, than cash. For example, Australian Bank shares offer investors a grossed up dividend yield of close to 7.0% per annum – that’s a significant uplift on the Reserve Bank ‘s 2.25% per annum cash rate. This appears as an appealing alternative to investors who can no longer stomach the opportunity cost of holding cash.

How important is yield in the investment decision making process?

Investment yield is only one part of the total return equation. Yet, yield seems to be dominating the current decision-making process for many investors. The most popular investment theme over recent times has been enhancing yield, and it has resulted in a proliferation of high yield financial products.

Financial product developers are great marketers – they’re usually more skilled at responding to what the market wants than they are in designing efficient financial products. As a result, we as consumers tend to get what we desire most, even if that’s not necessarily in our best interests.

All investments offer a total expected return made up of two components – income, or yield, and capital growth. The table below provides a summary of long term expected returns for the major asset classes that would generally be regarded as reasonable estimates.[1]

Asset Class Type

Expected  

Yield

Expected  

Capital   Growth

Total   Expected Return

Cash Defensive

5.0%

0.0%

5.0%

Bonds Defensive

6.0%

0.0%

6.0%

Australian Shares Growth

4.0%

5.0%

9.2%

International   Shares Growth

2.0%

7.0%

9.2%

Property Growth

6.0%

2.0%

8.1%

 

Cash and Bonds provide an “all yield, no capital growth” outcome for investors, (assuming the investments are held to maturity).[2] Shares and Property offer a total expected return that includes both yield and capital growth. Cash and Bonds (with no capital growth component) are classified as defensive asset classes, and Shares and Property (with expected capital growth components) are classified as growth asset classes.

The total expected return for the defensive asset classes is less than that for the growth asset classes. This simply reflects the higher risk associated with the growth asset classes. Typically though, the expected yield for the defensive asset classes exceeds the expected yield for the growth asset classes (with commercial property being the exception).

The Reserve Bank of Australia charts below provide an historical perspective of the long-term yields for cash, bonds and shares.

The charts confirm an average yield for Cash of around 5% (since 1993), around 6% for Bonds, 4% for Australian Shares and 2% for International Shares.

In recent times, however, the yields for the defensive asset classes, Cash and Bonds, have fallen below those offered by property and shares. This has resulted in some interesting decisions being taken by investors. The focus on yield as the primary determinant of investment strategy has led many to switch from defensive asset class exposure to growth asset class exposure. Unwittingly, for many at least, this has simply increased their investment risk exposure.

No matter how confident people are of the future returns for asset classes, they should always maintain a disciplined investment risk strategy. The whole purpose of the defensive asset component of your portfolio is to provide you with a defence against poor growth asset markets, not to provide you with high returns.

The reaction to the latest interest rate reduction by the Reserve Bank suggests that many have been abandoning defensive assets in favour of a yield based decision process. This approach, in our opinion, is likely to ultimately result in disappointment.

2014 provides a good example of investment yield acting as a distraction to good investment decision making. Yields for both Cash and Bonds were below the yield on Australian shares. This would have made Australian Shares the investment of choice for the yield seeking investor. In contrast, International Shares would have been avoided by such an investor, with yields below both Cash and Bonds.

The total return outcome (i.e. the most important outcome) for the 2014 calendar year shown below reveals no correlation between yield and total return. In fact, the lowest yielding asset class (International Shares) provided the highest return:

Asset Class Indicator Used

Commencement   Yield

Total   Return

2014

Cash Bloomberg AusBond Bank Bill Index

2.5%

2.7%

Australian Bonds Bloomberg AusBond Composite Bond Index 0+

3.7%

9.8%

Australian   Shares S&P/ASX 300 Ex A-REIT Index   (Accumulation)

4.3%

3.9%

International Shares MSCI World ex Australia Index (gross div.)

2.3%

15.7%

 

Never ignore the risk side of the investment equation

Investment decisions based on what seem to be the blindingly obvious (e.g. higher yield is better than lower yield) don’t adequately consider risk.

The most confounding situation arises with the investor who expects certainty and yet also expects a high rate of return. We maintain that if you are expecting a higher than average rate of return, you almost unequivocally are accepting a higher than average level of risk.

Risk and return are inextricably linked – choosing investments according to their yield ignores the risk side of the investment equation. In our experience, investors who forget this principle generally pay an unexpectedly high price for it.

[1] Note that these expected return rates are not a forecast of future returns, they simply provide a rough guide to reflect the relationship between the asset classes.

[2] Note: this also assumes no default from the provider.

Wealth Foundations (ABN 95 965 896 114) is a corporate authorised representative of Wealth Leadership Services Pty Ltd (Corporate Authorised Representative No. 319641). Wealth Leadership Services Pty Limited (ABN 36 121 535 993) is a licensed Australian financial services firm (AFS Licence No. 317369).