Low Returns Are Fundamentally Unstable


10 Year Treasury Rate – 54 Year Historical Chart

In my previous post, I discussed how investors seeking relative value tend to drive prices up and returns down over time. When returns are low, small changes in expected returns (or small differences in returns between investments) result in large price changes. Everything I know about human psychology tells me that humans are not well adapted for navigating low-return markets. I believe this makes low return environments fundamentally unstable. Before I say more on that, let’s look at an example of how low returns can cause large price changes for securities:

Let’s say the prevailing rate of return for low-risk investments is 1%. By prevailing rate of return, I mean the rate of return that is widely available with little risk of not achieving it, such as US treasury bonds. Now suppose investors find an investment with the same level of risk that has a 2% yield. Investors will prefer to buy the 2% yield investment over 1% yield investments. This will cause the price of the 2% yield investment to go up which will reduce the yield. Logically, the price should go up until the yield drops to 1%. How much does the price need to change for the yield to go from 2% to 1%?

If the 2% yield investment has an initial price of $100, that means it yields $2 per year ($2/$100 = 0.02). For the yield to be 1%, the price has to climb to $200 ($2/$200 = 0.01). That’s a 100% increase in price!

Think about that. You found an investment that paid $2 per year instead of $1 per year. When other investors notice the slight advantage of your investment, they will pay you $100, which is 50 years worth of returns from your investment!

Now consider the opposite scenario. Investors paid $200 expecting to receive $2 per year (1% yield). The investment does not perform as well as expected and investors realize they will only receive $1 per year. If the prevailing rate of return is 1%, investors should sell the security until the price falls to $100, where the yield will match the prevailing rate ($1/$100 = 0.01). That’s a 50% drop in price! The loss of $100 is equivalent to 50 years worth of return at the originally expected rate of $2 per year, or 100 years worth of return at the new $1 per year rate!

That’s not the only way for the price to drop 50%. Once again, let’s assume the investment initially costs $200 and yields $2 per year for a 1% rate of return. If the prevailing rate of return increases from %1 to 2%, the price of the investment should drop to $100 so that the yield will be 2% ($2/$100 = 0.02).

Are you surprised by the above examples? If you are, you’re probably not alone. I only realized this earlier this year. Few people seem to be aware of this basic math that applies to low returns.

The difference between $2 per year and $1 per year is large when compared to each other, but very small when compared to the price of the investment ($100 or $200). Small changes in the expected return or the prevailing rate of return cause very large changes in the price of the security that are equivalent to decades of returns. This is the kind of fragility that Nassim Taleb talks about: minor shocks or errors in forecasts can result in large losses. Note, however, that the potential gains are also large. If an investment returns slightly more than expected or the prevailing rate of return goes even lower, the large adjustment in the price of the investment is a huge gain for investors who already held it. This contributes to the difficulty of navigating low return environments: there is both high risk and high reward.

We don’t know the future. Inevitably, our expectations about future returns or the prevailing rate of return will have to be adjusted. Even relatively small adjustments can result in large price changes as we saw in the examples above. It’s these large price changes that are likely to trigger irrational behavior. When prices change a lot, we are more likely to feel like we need to do something. We feel more comfortable in groups and if we aren’t sure what to do, we tend to follow what the people around us are doing. That means we are likely to act in ways which make price changes even larger. Larger price changes cause more people to act, which makes the price changes even larger… It’s human behavior that causes the instability.

Remember, the price changes don’t have to be large losses. They can also be large gains. When the prices of securities are going up quickly, we feel more inclined to buy them. If we have cash available, many of us do buy them, which causes the price to go up even more. Prices are likely to overshoot value, which means future returns will be lower. If low returns are unstable, even lower returns are even more unstable. An unstable system can become more unstable, but it’s difficult for it to stay that way. Eventually, the system will return to a more stable configuration.

So what is a more stable rate of return? Let’s look at another example:

Let’s say the prevailing rate of return is 5% per year. A $100 investment at this rate returns $5 per year. If the actual return ends up being $4 per year, how much does the price of the security need to adjust to bring the yield to 5%? The price should drop from $100 to $80 ($4/$80 = 0.05). The 20% drop in price is equivalent to 4 years of returns at the original rate of $5 per year. That’s substantial, but nowhere near the 50 years worth of returns in the earlier example when the prevailing rate was 1% per year.

Simply by starting at a higher rate of return, the consequences of a small change in the return of an investment were reduced dramatically. Smaller price changes are less likely to be amplified by human behavior, enhancing stability. This might partially explain why historical returns have been closer to 5% per year than to 1% per year.

If you believe the 10-year US treasury bond is close to the prevailing rate of return, then the prevailing rate of return is currently close to 2.16%. It hasn’t been above 5% since 2007. We have been in a low return environment for many years. At some point in the future, it’s likely that returns will be higher since that will be a more stable situation than what we currently have. It’s worth keeping in mind that we don’t know when that will be. It might be tomorrow or ten years from now. There are multiple ways we can get there:

  1. Prices decrease suddenly or gradually while returns stay about the same.
  2. Prices increase suddenly or gradually, then decrease even more while returns stay about the same.
  3. Prices stay the same while returns gradually increase.
  4. Prices increase. Returns increase even faster.
  5. Returns decrease. Prices decrease even faster.

I don’t know which of these scenarios will occur. Scenarios 4 and 5 seem unlikely, but I might be wrong. I hope for scenario 3, but scenario 2 seems more likely to me. There may be other scenarios that I failed to consider. Returns may stay low for much longer than they already have. A prudent investor is prepared for more than one of these scenarios.


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