Low Interest Rates Don't Build Wealth

Low interest rates are celebrated by financial markets. They make other asset classes look relatively more attractive and drive the prices of equities, property and bonds higher. We all feel wealthier (not to mention smarter!) because the market value of our house, shares or retirement savings has risen.

If we wanted to spend all our money on hamburgers tomorrow, this might be fair enough, with lower interest rates we can buy more hamburgers than we could before. But for most of us the purpose of investment portfolio is to provide for the long term needs of ourselves and our loved ones. Our intrinsic spending needs are spread into the distant future.

In this sense low interest rates don’t help at all. (Note that we are talking about real interest rates, or interest rates minus inflation). Though the ‘net present value’ of your investment might have increased, if the expected cash flows from the investments haven’t changed, the ability to service future spending needs hasn’t changed either. Whilst we often think in terms of the ‘present value’ of investments, the core goal of investing is to maximise future values not present ones.

Any investor who depends on the income from their portfolio will understand this immediately. While your financial advisor might try and convince you that your portfolio generated a lot of wealth last year, if anything your expected income would be lower in 2014 than 2013, thanks to lower interest rates.

Here's a classic example of the confusion. Movements in interest rates cause short term volatility in capital markets which makes some investors retreat to the supposed safety of cash or short-dated bonds. Looked at from the point of view of future values you can see this approach is wrong-headed. Defensive stocks and long dated bonds, with their secure long term cash flows, in fact provide the most sure future values.

The stability of cash for long-term investors is illusionary since its future value depends heavily on interest rate levels; if interest rates fall its future value degrades badly.

When investing we’re all much better off focusing on profits, cash flows and dividends. Interest-rate driven movements are mostly a distraction.