With Low Rates on the Horizon, Stay Mindful of Downside Risk

Given the prospect of low future returns, Perkins Chief Investment Officer Gregory Kolb explains why he believes investors should focus on minimizing downside risk while seeking overlooked value opportunities.

Key Takeaways

  • Low bond yields and high equity valuations suggest future returns could be low, extending the time it will take for an investment to increase in value.
  • Faced with this possibility, many investors have opted to take on more risk, opening themselves up to potential psychological and portfolio stress should volatility return to markets.
  • We suggest taking a more balanced approach that accepts the reality of high current valuations and aims to participate in any future gains but also acknowledges the growing risks.

In years past, the “Rule of 72” provided a simple shortcut for estimating how long it would take for an investment to double in value. While less precise than the logarithmic equation required to produce an exact answer, the rule – in which the number 72 is divided by the rate of return – has yielded surprisingly accurate results.

For example, an investment compounding at an annual rate of 7% (the yield on the 10-year U.S. Treasury bond in April 1995) would roughly double over a 10-year period (72/7 = approximately 10 years). The math is easy, and the concept itself is encouraging: Work hard, save a healthy amount of income and let the power of compounding do its magic.

How quaint it all seems now. With the yield on the 10-year U.S. Treasury hovering around 1.6% as of early February, the timeframe needed to double one’s savings is increasingly stretched. As the rate of return falls from 2% to 1%, the timeframe leaps from 36 to 72 years! More importantly, the outlook for future returns generally seems low, with the S&P 500® Index trading at more than 18x estimated earnings over the next 12 months – a post-dot-com era low.

As Rates of Return Fall, the Timeframe for Doubling Value Rises Dramatically

Source: Perkins Investment Management. The curve is derived by dividing 72 by the rate of return (Y-axis). Years required to double an investment are shown on the X-axis.

 

A key question – perhaps the question – for today’s investors is how to position a portfolio for a likely low-return environment in the future. For many years, the answer had been to take more risk. However, in our opinion, many of the “risk-on” investment choices of the past – lengthening maturities, lowering credit quality, increasing leverage, etc. – could make investors more vulnerable to losses and create significant psychological and portfolio stress should volatility return to markets.

A More Balanced Approach

Rather than throw caution to the wind, we recommend taking a more balanced approach that accepts the reality of high current valuations and aims to participate in any future gains but also acknowledges the growing risks. As valuations have generally become more elevated, investors need to be aware of and think carefully about the loss potential of an investment.

We also believe it can be fruitful to go off the beaten path in the search for value. As markets ratchet higher, most “obviously” attractive companies have been recognized as such by bullish investors, so it may be necessary to “turn rocks” to find attractive reward-to-risk ratios.

Going back to the Rule of 72, remember that the basic point of investing is to compound returns. For investors who save and invest a portion of their income, the power of compounding can do wonders for a portfolio over time. However, despite markets reaching all-time highs, the harsh experience of past market cycles should not be forgotten. As history shows, the investment opportunity set tends to change over time, is occasionally extremely compelling and, in any case, usually offers higher forward rates of return than what we are seeing today.

Whether the timeframe to double is short or long, investors should keep risk in mind as they make their investment selections.

For more insights on how investors may uncover opportunities amid market uncertainty, read the full 1Q Perkins CIO Outlook.