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.
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Note: An earlier version of this article was published at The Good Investors, a personal blog run by our friends.
Disclosure: Jeremy Chia does not own share in any of the companies mentioned.