Q:We have had low interest rates for many years so it could be said with near certainty that rates will go up in the future?
Yes, but the actual timing is being continually postponed. Other than a vote for Brexit this month, there is no obvious reason for a significant change in the short term. Investors requiring income have seen the interest paid on cash deposits evaporate such that many have been forced to seek income elsewhere.
Q:Where are they looking?
The first step up the risk spectrum would be UK gilts, but the yield on these is similarly modest, so investors have been moving further up the risk scale to corporate bonds including those offering a “high yield” but a weaker covenant. So we have had low-risk savers investing in riskier assets in the chase for yield. Compounding this is the fact that these very assets are the most exposed to an interest rate increase when it finally arrives. The focus on yield has inadvertently pushed cautious investors into traditionally low-risk asset classes but at exactly the time when they become high risk.
Q:What should investors do?
I don’t necessarily believe in market timing but I do believe in the long-term returns from equity markets. Where possible, investors should focus on the total return from their portfolio, rather than just on the income generated. As ever in investment, the answer then lies in diversification: a portfolio spread across a range of asset classes that will include an element of gilts and corporate bonds, but also diversification into equities and other asset classes which offer the potential of returns with low correlations. In a perverse way, by increasing the exposure to traditionally “higher risk” assets an investor can capture other sources of income and capital growth, but without necessarily increasing their overall risk exposure.
Q:Where do advisors come in?
The one caveat is to discuss risk with their advisor before making any such investment. There should be three components to this discussion. The client’s risk tolerance will normally be assessed by a psychometric questionnaire. The risk required will be based on the rate of growth necessary to meet their future goals. And the risk capacity – or “capacity for loss” – will take account of their timescale and their withdrawal rate. These three factors will often produce a mismatch, and it is the job of the adviser to guide the investor through this to reach a conclusion and to give them a realistic expectation of the return and risk that should accompany their portfolio. The final stage then is to agree a sustainable rate of withdrawal – income – from the portfolio, based on the investor’s requirement for income, inflation assumptions, the agreed risk categorisation, and whether or not the portfolio value is to be retained or can be gradually depleted.
Q:How do you balance protecting and depleting the portfolio’s value?
We all know about the benefits of pound-cost averaging when making regular savings. The opposite is the case when drawing down from a portfolio. Unsustainably high withdrawals during times of market weakness can quickly lead to “pound-cost ravaging”! While not wishing to pronounce on future equity markets, the first half of 2016 is a better entry point than the market highs of last summer. Holding cash carries interest rate risk and inflation risk. Cash-rich investors with a sufficiently long time horizon may look to swap these risks for different ones, but ones with the potential to give a more pleasant investment experience in coming years.