How to Invest in a Low Interest Rate Environment

10 August 2016  |  Simon Miller
How to Invest in a Low Interest Rate Environment
The Bank of England has set UK interest rates at an all time low of 0.25% and while individuals look to the capital markets as a means to build wealth for their retirement, we highlight some of the common pitfalls to avoid when investing.

It will take a lot of time to really understand the full impact of Brexit, but one immediate impact in the UK is the interest rate environment. The base rate set by the Bank of England is now 0.25% following a deteriorating economic outlook and revisions to the UK’s GDP (Gross Domestic Product) forecasts from the Monetary Policy Committee.

What does it mean for savers and investors?

With rates almost at zero the main impact for savers is that they will struggle to find any significant return on cash investments. Cash ISAs are now offering interest rates of around 1% which is a big change from before the Financial Crisis in 2008 where they averaged above 5%. What hasn’t changed is the fact the people still need to save and need to build their wealth. The sad reality in the UK is that we have a pension crisis, meaning if you don’t start planning and saving for later life, you’ll have to keep working far longer than any generation gone.

Interest Rates Are at an All Time Low

% Interest Rate from 1975 to Present

% Interest Rate from 1975 to Present
Source: Bank of England

But I can borrow money more cheaply?

Lower interest rates mean you can borrow money more cheaply and mortgage rates will also drop, meaning houses might look slightly more affordable. Unfortunately this is a short term effect and those people who are naive enough to take on more debt or stretch themselves to buy a home, are digging themselves a hole, which in some cases they may never get out of. Interest rates won’t be low forever and home prices won’t rise forever. So while that loan/mortgage may appear affordable now, what happens in five years time when you approach the bank with interest rates 1-2% higher and your home price unchanged, or worse, lower than it is now?

Such a scenario is hardly an extreme outcome. Extreme would be stagflation as was seen in Japan from 1995-2005 where despite interest rates being low, asset prices (including property) tumbled while wages shrank and GDP fell. To predict this in the UK would be scaremongering but the point it highlights is that central bank or government stimulus doesn’t always have the desired effect and certainly not with a predictable time horizon.

Returning to the fact that people need to save and plan for retirement, the obvious next question while interest rates are so low is how to get a return. Unfortunately saving in itself is often not enough. A good example of this comes from Germany where they are among the best savers in Europe, saving around 10% of their annual income (vs 3.8%1 in the UK). Unfortunately with over €2billion sitting in savings accounts earning no return, the Germans are among the poorest in terms of financial assets, holding only marginally more per capita than the likes of Portugal, Spain and Greece.2

Minimising costs and controlling risks is more important now than ever.

Investing is the solution

Regrettably, things are never quite that simple; investing in a low interest rate environment unearths and amplifies some of the pitfalls associated with the world of investing. Firstly costs become all the more significant when returns are much harder to come by. Paying 2% or more in fees may not seem unbearable while equity markets are returning an average of 6% per year. However with equity markets at all time highs and risk premiums suggesting that the new normal would be closer to 4%, then costs all of a sudden move closer under the microscope. Secondly, it is evident across global economies that we are in a period of increased uncertainty and with increased uncertainty will come increased risk (volatility) in financial markets. So while investing is attractive to savers as a means to grow their wealth in the long term, jumping into the capital markets could be a very brief and costly experience. That is unless individuals understand how much risk they can tolerate and invest in a way which keeps them within their limits.

At Scalable Capital we have developed a service which is enabled through technology and allows us to offer a sophisticated investment management service at a fraction of the cost of traditional providers. In addition what makes us truly unique is our approach to risk. We give our clients a quantifiable measure of how much risk they are taking with their investment. Our model then monitors their portfolio daily and we adjust clients’ allocations over time, to ensure they aren’t exposed to more risk than they can tolerate, so that they stay invested and benefit from long-term capital market growth.

1 Office for National Statistics – % Savings of household resources
2 Allianz Global Wealth Report 2015

Photo by George Rex

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Simon Miller
Formerly a derivatives trader at Barclays Capital, Simon merges capital markets knowledge and business development skills with an academic background in Economics, Business and Mathematics.