The dynamics of investing change as an economy shifts from high to low cash rates.
The most obvious change will be that overall investment returns decline after a temporary boost to stocks and bonds.
Generally, bond yields will be lower and the slowdown in economic growth will cap future equity returns.
One of the less obvious changes will be that sound financial advice becomes even more important for investors.
Only a few years ago, Australian investors were earning 5 per cent to 8 per cent simply by parking their money in cash investments such as term deposits. However, as cash rates have dropped, the same investments today are struggling to earn 3 per cent to 4 per cent. Investors understand they need to find new sources of return but given the lower headline yields, they’re asking why they need a financial adviser.
Their investment returns need to be significantly higher to justify the cost of financial advice. Studies show good financial advice can make a huge difference in returns over time. According to a study by Aon Hewitt and Financial Engines, titled ‘Help in Defined Contribution Plans: 2006 Through 2010’, pension plan participants who relied on financial advice earned returns almost 3 per cent higher – after fees – than plan participants who invested on their own from 2006-2010. To illustrate the impact, the study noted that an investor who earned an additional 3 per cent return on an initial investment of $10,000 over 20 years would have 70 per cent more wealth.
During the period covered by the study, interest rates fell to near zero in the United States and in one year alone (2008), the stock market, as measured by the S&P 500 Index, dropped 38 per cent. In that light, an additional 3 per cent in return every year takes on greater significance because it represents a bigger proportion of overall returns. A low-return world then is one in which sound financial advice is potentially very valuable to investors.
The Aon Hewitt-Financial Engines study concluded that there are two reasons for the lower portfolio performance for investors who did not use financial advice. Firstly, inappropriate risk levels – often too much but sometimes too little – and secondly, inefficient portfolios, which earned lower returns than they could have for the amount of risk they took.
As the Australian economy slows down, and cash or policy rates remain low with the potential to fall further, many investors will find the low-return world challenging and frustrating. For financial planners, this is the time to begin demonstrating the value of sound financial advice by steering clients toward appropriate risk levels and helping construct portfolios in which returns are proportional to the risks involved. Assessing carefully the expected returns on investments is more important than ever in achieving the right balance.
