Do We Ever Really Know What to Expect From Rising Interest Rates?
In December, the Federal Reserve raised the federal-funds lending rate by .25%, only the second increase in the past decade.
The day the rate hike was announced I received several calls from journalists, all wanting to know what this means for the economy. My email inbox also started filling up with questions about the effect rising interest rates will have on real estate and stock investments.
My best answer? We never really know what to expect from rising interest rates. The core driver of all free markets is people’s behavior. And our behaviors are largely driven by emotion rather than logic. Even when we think we are being logical, we are often reacting emotionally. Daniel Kahneman’s research shows that we make 90% of all financial decisions emotionally, not logically. It took me some time to accept the truth of that research and the reality that it did apply to me, too.
Let’s consider what rising interest rates might bring to the various markets.
The first asset class we usually become concerned with is the bond market. This is where people and organizations lend money to corporations and governments, in turn receiving a fixed interest rate over a period of time that is typically 3, 5, 10 or even 30 years.
Suppose you bought a bond in which you loaned money to the US government for 30 years at 2.5%. If the going rate increased to 4.5%, you would not be very happy. You would be losing 2% a year in potential income you might earn if your money wasn’t tied up in the 30-year bond. Since the bond isn’t due to be repaid for 30 years, the only way you can get out of it is to sell it. No one is going to want a bond paying 2.5% when they can get 4.5%, so you are going to have to take a loss and sell the bond at a discount. So clearly, when interest rates rise the holders of long-term bonds get clobbered compared to shorter-term bonds.
The reverse is also true. If interest rates go down, the longer-term the bond the more valuable it becomes, as investors become willing pay a premium for bonds with a higher interest rate than the current market rate.
It's hardly surprising, then, that when interest rates are rising many advisors recommend holding short-term or intermediate-term bonds that mature or pay off in 1 to 5 years. The idea is that when interest rates rise, the price decrease of shorter-term bonds is less because of the shorter time to maturity when you get your money back and can reinvest at the higher rates.
From this you might logically conclude that, when interest rates rise, long-term bond prices always fall. Not necessarily.
Dimensional Fund Advisors carried out a case study of four periods of 12 months or more during the past 30 years when interest rates rose 1.5% or more. The periods were December 1976–March 1980 (when rates skyrocketed by 15.25 percentage points), September 1992–June 1995 (3 points), November 1998–December 2000 (1.75 points) and June 2003–August 2007 (4.25 points). Notably, in two of these four periods of rising interest rates, long-term bonds did better than shorter-to-intermediate-term bonds. In the other two periods (1998–2000 and 1976–1980), longer-term bonds did worse than short-term.
The bottom line is that we can’t depend on any markets to be logical. The bond market, like the stock market, is a free market driven by emotions. This human factor is a good reason not to take bets with your long-term investments on what the market response will be to anything.
Cyborgs Are the Future for Advisors
Becoming cyborgs is the way to go for financial advisers…blending robotics and humans into one organism.
You see, I am convinced that robo-advice models will succeed and prosper.
I am also convinced that human advisers will succeed and prosper.
I am further convinced that some of each will fail entirely and die, but in Darwinian fashion the most adaptable will survive and prosper. Smart financial advisers will work out how to become cyborgs and build an offering which is a blend of human and machine – or at least their practice will.
Despite the fear-mongering when it comes to robo’s the reality is that there are many great arguments for automated transaction systems, or robotic product delivery. Cost reduction for the consumer, cost reduction for the practitioner….efficiency, speed, convenience for all….elimination of the frustrating and time consuming service model supplied by the industry to low value transactional customers….and let’s be bluntly honest: some people DO just need a product solution at some stages of their life, and DO NOT need holistic advice at some points.
Robo-advice makes sense commercially, and it can meet a need in life stages planning for many consumers. It also happens to appeal to a segment of society who are happy to make their own decisions and transact from the comfort of their pyjamas during the ads in their evening television program, and who are unlikely to engage in full advice. It is worth remembering that this last type of consumer segment is growing at the expense of the traditional intermediated product delivery systems of distribution.
However, machines do not “manage” relationships and behaviour – humans manage humans. Humans tend to rebel against the concept (or slightest inference actually) that they are being manipulated or are at the mercy of computers and machines. Machines and automated systems exist for our convenience, don’t they? Nobody wants a “SkyNet”.
……So the human adviser remains in the equation……
When we strip out all the industry jargon and hyperbole the primary function of a financial adviser is to manage clients behaviour. We don’t really manage their money – other people do the actual money management. We don’t supply products….we source them from a supplier. What we do is manage their behaviour and expectations. We coach them. Machines don’t do that yet….and when they are able to (and they will be), most consumers will shy away from being managed by a machine.
But we cannot escape those arguments supporting robo-offerings as they make too much sense for clients and for us. In fact I suspect robo-advice will be a very good thing for smart adviser practices.
Believe it or not, I believe robo-offerings can help us get clients.
For most consumers there is a period early in life when their financial advice needs are fairly basic, and also there is a period later in life where all the planning has been done and consumers are moving into “drawdown” territory. In between those times, life gets somewhat busier and complexity increases substantially.
Advice delivered by humans should be focussed upon the complexity phase. Apart from the fact that this is the period of a consumers life when there are the most variables to consider in their planning needs, it is also the phase where behaviour management is a distinct help to the achievement of the consumers goals and objectives. Generally people will only do uncomfortable or new things if they have a high degree of trust and confidence in the person guiding them to do so, and establishing that level of trust – or the bond between two people – is where robo-offerings will struggle to compete.
However, when it comes to identifying a fairly simple need which has a product solution then robo’s will certainly be able to deliver a solution more cost effectively and faster than the human adviser can, who is bound by increasing complexity of their own called “compliance” every time they have to interact with another human being.
The smart adviser will identify those areas of their clients lives and those product solutions which work well for those times and find a transactional solution for their clients to access. They will build that transactional, no-advice, solution into the service offering that their practice puts into the market. In other words they will embrace and incorporate robo-offerings into their business model.
Not just because consumers want them or need them, and not just because it is cost effective to do so. Not even because we’d like to have a commercial revenue stream which sidesteps the more time-consuming (and therefore labour intensive and expensive) compliance requirements.
The reason smart advisers will do it is because it will help gather the next generation of clients for the firm before the complexity triggers drive them to seek advice elsewhere.
The robo-advice solution caters to those who have an identifiable need for financial services of one sort or another, but who do not yet need holistic bespoke planning. It is an entry point for consumers to become customers of the firm, and for the firm to then work upon converting those transactional customers into advised clients for the future.
Robotics are a part of our world and our future. We need to figure out how to make them a part of our business too, but in such a way that our business uses the robo’s, rather than being used by them. Humans and robo’s integrated into the same service business in order to deliver they type of solutions and assistance that consumers and customers and clients want at different stages of their life.
The future for the financial advisory practice is cyborgs.
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