FOOL'S EYE VIEW
Are You Ready For Low Returns?

By Stuart Watson (TMFTiger)
February 5, 2002

Great Titchfield Street, London -- One of the main themes in financial punditry over the last year or so has been adapting your approach to the "low inflation" area. Long-dated gilts  now return around 4.5% to 5.0% indicating that inflation is expected to remain at its current low level for the next 20 to 30 years. That may not turn out to be the case, of course, but it's the best guess we have. Assuming it does come to pass, what does it mean for the major financial choices that we all make? Surely we should all take on loads of cheap debt and churn our portfolios in order to improve our returns?

Er, no.

Your Mortgage & Other Debts

As inflation is low at the moment, interest rates are also very low too -- in absolute terms anyway. You can pick up a mortgage for 5% without too much trouble. You can get a personal loan for 10% or even less. These low rates have led many of us to believe that we can take on more debt because debt is cheap. After all, the cost of servicing that debt from month to month appears much lower. But it isn't that simple when you consider the true cost of these debts over the whole life of the loan. You need to consider the real cost of borrowing, that is, the absolute rate less inflation.

As always, an example may make things clearer. Imagine you're buying a house for £100,000, with a full 100% mortgage. A 5% mortgage rate means that this will cost you around £420 a month in interest plus whatever capital you chose to pay off on top of that. Let's say that for a standard repayment mortgage, you'd be paying £500 per month.

Back in the 1970s and 1980s, inflation would come to your rescue. Suppose inflation was 6%, your house increased in value by 8% per annum (that is, a real rate of growth of 2%) for the next 15 years and you kept paying your £500 per month on the mortgage. At the end of year 15, you'd have paid a total of £90,000 on the mortgage, but the value of your house would be around £320,000, giving you a comfy £220,000 in equity plus whatever part of the mortgage you had paid off in the meantime. On top of all that, your payment of £500 a month would have shrunk to a much more manageable £210 in terms of spending power 15 years hence. Great stuff!

But say inflation was just 2% (as it is now) and your house increased in value by just 4% per annum (giving the same 2% real rate of growth). In year 15, after paying £90,000 on the mortgage, the house would only be worth £180,000 and in real terms your monthly mortgage payments would still be around £370 per month. Uh oh, not so great.

Not only might big gains in house prices be a thing of the past, but you're saddled with a higher level of debt (relative to your take-home pay) for a lot longer. Think about that before you take out a big mortgage, second mortgage for a buy-to-let property or personal loan for that flashy new car. Whereas in the past, inflation would have helped you to reduce the debt to manageable levels (although it was tough for the first few years) that's not going to be the case any more. Now the pain is more evenly spread throughout the life of the loan. So if you have trouble paying it off in the early days it probably means you will continue to struggle for many more years. Cheery stuff. The answer, of course, is not to get into too much debt in the first place.

Your Investments

Another common piece of punditry you'll hear these days is that you need to manage your investments more actively because the returns of the stock market as a whole are much lower. In absolute terms that is likely to be true. In real terms it is arguably not the case. For me, investing is much more about increasing my net worth a greater rate than inflation so that I can have a comfortable retirement. In other words it's worth making a few sacrifices now in order to avoid being forced to make many more later on.

This means low absolute returns are less relevant, as long as in real terms my retirement pot is still showing a reasonable rate of growth. The net gains that everyone makes from share investing cannot exceed the total increase in stock market value over the period of time that you are looking at. Buying and selling more frequently does give you the opportunity to outperform the average but it is more likely that your performance will actually be worse because of the higher costs you incur.

There seems to be no end of brokers appearing in the press and on TV these days telling us we need to churn our portfolios more often. Of course they omit to mention that their slice of the pot, i.e. trading commissions, will be higher as a result. I'm sure they were going to mention it but it just slipped their mind.

Another potential danger here is that people get sucked into high-income schemes that promise far more than they can ever hope to deliver. As an income investor, it's true that you are getting less for your money these days. But the flip side of this is that the capital value of the investments you use to generate this income is reducing much less rapidly too, at least in real, post-inflation, terms. So although the current level of income may be low, the capital used to generate it should last a lot longer. It's the exact opposite of the debt situation.

So, all in all, perhaps not that much has changed. The basic principles of keeping your costs low and not getting dragged into debt still apply as much as they ever did, low inflation or not.