A few months back, the US Federal Reserve slashed its benchmark interest rates to between 0% and 0.25%. The last time it was this low was in late 2008, during the throes of the Great Financial Crisis. Now, with the near-term economic impact of the COVID-19 crisis still unknown, there’s also the possibility that the benchmark interest rate in the US could move into unprecedented negative territory.
This gives us investors a dilemma. In this low rate environment, should we invest in higher-returning but riskier asset classes, or stick to lower-risk but ultra-low-yielding investments?
The search for higher returns
Interest rates are an important determinant in the long-term returns of most asset classes. In a low-interest-rate environment, corporate bonds and treasuries naturally have low yields. Holding cash is an even less attractive proposition, with bank interest rates almost negligible.
In a bid to get higher returns, stocks may be the best option for investors.
How much is enough?
According to Trading Economics, interest rates in the US had averaged at 5.59% from 1971 to 2020. Meanwhile, the S&P 500 returned approximately 9.3% annually during that time. In other words, investors were willing to invest in stocks to make an additional 4% per year more than the risk-free rate.
This makes sense, given that stocks are also more volatile and are considered a riskier asset. Investors, therefore, will require a return-premium to consider investing in stocks.
But interest rates then were much higher than they are today. With the benchmark interest rate in the US now at 0% to 0.25%, what sort of expected returns must the stock market offer to make it an attractive option?
I can’t speak for everyone but considering the options we have, I think that as in the past 50 years, a 4% spread over the risk-free rate makes stocks sufficiently attractive.
The big question
So that naturally leads us to the next question. Can investing in the S&P 500 index at current prices give me a 4% premium over the current risk-free rate.
Sadly, I don’t have the answer to that. The S&P 500 is a basket of 500 stocks that each have their own risk-reward profile. With so many moving parts, it is difficult to quantify how the index will do over the long run. Similarly, other indexes are difficult to predict too.
However, I know that there are individual companies listed in the global stock markets today that could provide an annual expected return of much more than 4% over the risk-free rate.
By carefully building a portfolio out of such stocks, I think investors can navigate safely through the current low-interest environment and still come up with decent returns over the long term.
A few months ago, my blogging partner, Ser Jing, shared his investment framework that helped him build a portfolio of stocks that compounded at a rate that is meaningfully higher than 4% a year (19% to be exact) from October 2010 to May 2020.
Using a sound investment framework, such as his, to build a portfolio may be all you need to navigate through this low-interest-rate climate.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.