Brent Sheather: As simple as possible, but no simpler

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Brent Sheather is an Authorised Financial Adviser and a personal finance and investments writer.

Reading an article in the finance section of a Sunday newspaper the other day I was reminded of a quote which has been attributed to Albert Einstein.

He apparently said that "everything should be made as simple as possible, but no simpler". What he was probably meaning here is that the goal of a theory is to describe a reality as simply as possible with deference to the un-informed reader whilst not offending the expert. Someone else alluded to this objective when he said "for every problem that is muddled by over-complexity, a dozen are muddled by over-simplifying".

The article in question discussed the recent move by the NZ Reserve Bank to cut the Official Cash Rate from 2.75% to 2.5% under the heading "Reserve Bank Governor has lowered interest rates". That was the first over simplification.

In fact what the Reserve Bank Governor did was act to lower short term wholesale interest rates. He has less control over local medium term rates, longer term interest rates and credit spreads and no control over offshore rates.

Long rates can in fact move inversely to short rates, indeed when the US Federal Reserve raised short term interest rates the other day longer term rates actually fell.

The writer went on to say that investors with diversified portfolios i.e. bonds, property and shares need not be too concerned with a fall in interest rates as shares would do better as a result of lower interest rates, all things being equal. Again, too simple, as unfortunately all things aren't equal. Interest rates do not fall for no reason.

Usually a fall in interest rates is associated with a reduction in economic activity and/or inflation in the future so the fall in interest rates often coincides with diminished corporate profit growth.

The writer went on to cite the theory of the equity risk premium (ERP) and, in his second over-simplification, said that if interest rates fall the excess return from shares increases. He said "the higher equity risk premium that Mr Wheeler has just given us makes shares more attractive and therefore they are likely to rise".

Before we look at these latter comments lets back up the bus a bit and consider what is meant by the ERP. Investopedia defines the equity risk premium as "the excess return that investing in the stock market provides over a risk-free rate such as the return from Government bonds. This excess return compensates investors for taking on higher risk".

The basic idea of ERP isn't rocket science nevertheless there is a lot of argument over the historic risk premium let alone what number we should expect in the future.

Two local academics, Bart Frijns and Alireza Tourani-Rad from Auckland University of Technology, recently wrote about the NZ stock market's risk premium in the INFINZ Journal, using 115 years of data. Their view is that as markets are volatile obtaining an accurate estimate of the risk premium is difficult and "this problem is compounded by the fact that concentrating on the recent performance of stock markets can result in erroneous estimates of the ERP".

In contrast the writer calculated the risk premium by subtracting a single observation of a bank deposit rate from an assumed 9% equity market return.

This is an overly simplistic approach which could give rise to error - firstly, in that the writer hasn't said how he derived the 9% return and secondly when calculating the equity risk premium, most analysts use long term bond yields. For example Frijns and Tourani-Rad use the 10 year government bond yield. Using this flawed methodology the writer arrived at a 5.5% equity risk premium whereas most forward estimates of the ERP are in the 3-4% range.

To suggest, as the writer did, that the Reserve Bank initiated fall in short term rates would be immediately compensated by higher returns from equities as a result of an elevated MRP is also simplistic.

Indeed research by Dimson, Marsh and Staunton (DMS), authors of the Global Investment Returns Yearbook (GIRY) finds that returns from shares are usually low at times when interest rates are low. This column looked at this phenomenon back in February 20th 2013 in an article entitled "Long Term Returns".

This story recounted research from the DMS 2013 Yearbook which showed that historically returns on shares have moved proportionately to real interest rates i.e. when real interest rates are low like they are now prospective returns from shares are also low. The professors state the obvious - the theory says the return on shares is equal to the risk free rate of return plus the risk premium and that "it follows that if the risk free rate is low then the return on equities should also be low". This is the exact opposite of the Sunday newspaper writer's contention.

What is also a little distressing about the article was that it was written by an authorized financial advisor (AFA) who had undertaken the exams to qualify as an AFA and (presumably) undertakes regular continuing professional development.

If the NZ financial advisory profession is to regain the confidence of the public let alone be treated as a profession like accountants and lawyers its advice and public commentary must be consistent and have regard to investment theory. The difference between the AFA's 5.5% ERP and most experts' 3-4% figure is significant for mum and dad investors. A retail investor who is told to expect a 3% ERP is likely to be far more cognisant of fees than someone who is told to expect a 5.5% ERP. The theory isn't perfect and it is sometimes complex nevertheless it doesn't deserve to be muddled by over simplification.

The financial media generally need to lift their game and avoid mistakes.

For example, the other day one finance writer described "laddering" fixed interest portfolios as "choosing the highest rate". Fail. Laddering itself is an oversimplification of the process of managing the duration of a bond portfolio. It has nothing to do with choosing the highest rate, in fact, one can only do that with hindsight. For example, if you are confronted with a one year rate of 6% and a five year rate of 4% what is the highest rate? You don't know because the one year rate is 6% but then the next four years is unknown so if they end up being 2% then the five year rate was superior. Basic stuff.

We need to be a lot more proactive and rather than just accepting dubious comments from interested parties like fund managers we need to add value by asking the hard questions like where is the research backing up the assertion? For example, on a financial advisor website the other day a fund manager was quoted as saying "A good advisor may on average generate 1% or 2% pa in additional returns through prudent asset allocation and selecting good funds or stocks." Really? Additional returns over what? Adjusted for risk? Where is the supporting research?

Absent the facts all we are left with is wishful thinking.

Brent Sheather is an Authorised Financial Adviser. A disclosure statement is available upon request. Brent Sheather may have an interest in the companies discussed.