How will conservative investors -- retirees, for example -- behave when interest rates go negative?
I ask even though rates in the U.S. aren’t negative -- yet. But they’re a lot closer to negative territory than they were just three months ago, and our president wants them to go negative as soon as possible.
Up until recently, investor behavior in a negative rate environment has received relatively little attention from researchers. But a recent study helps to overcome this lack. Titled “How Negative Interest Rates Affect the Risk-taking of Individual Investors: Experimental Evidence,” the study was conducted by three researchers at the University of Münster in Germany: Maren Baars, Henning Cordes, and Hannes Mohrschladt. Germany, of course, has had negative interest rates for some time now. An excellent summary of this study was recently provided by Larry Swedroe, chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
The study’s authors found that stock-bond investors do not significantly increase their equity exposure as interest rates decline -- so long as rates stay positive.
But when rates go negative, they suddenly increase their portfolio allocation to equities by significant margins.
Such a shift would undoubtedly prove to be a big boost to the stock market, of course. And some cynics believe that’s why there is such strong support in some circles for negative rates.
But negative rates hardly seem like a good reason for retirees and pre-retirees to significantly increase their equity allocation. The factors that cause interest rates to go negative don’t necessarily cause equities to become more attractive, either in absolute terms or relative to bonds. If anything, they mean just the opposite.
Nicholas Bloom is an economics professor at Stanford University and co-director of the Productivity, Innovation and Entrepreneurship Program at the National Bureau of Economic Research. In an email, Bloom told me that “interest rates are an excellent predictor of long-run growth potential, and their moribund level [today] reflects the markets’ expectation of sustained low future growth.”
So a rational response to negative interest rates would be to reduce the expected long-term return on our equity investments.
Why would investors nevertheless respond by significantly upping their equity exposure? The study’s authors believe it traces to investors’ great reluctance to take a loss.
This reluctance, referred to by behavioral economists as loss aversion, has been widely documented, and many studies have found that it helps to explain a number of otherwise inscrutable features of the market -- everything from support and resistance lines on a price chart to the tendency of stock prices to exhibit momentum. So it makes sense from a behavioral perspective that negative rates would have an outsized impact on investors’ stock and bond allocations.
But just because investors’ loss aversion is understandable doesn’t make their behavior rational. Negative rates, if and when they do happen, most likely will usher in a new era of anemic economic growth, and if we’re rational, our expectations will come down accordingly.