To answer this, first we need to understand what inflation is.
From an earlier article explaining inflation –
Each year the Reserve Bank of Australia releases more money into circulation.
But because the total combined amount of money has the same value, each dollar is now worth less to make up for the extra dollars in circulation. This devaluing of the dollar is called inflation.
Remember back when milk was $1 and now it’s more than double that? It’s not that milk is more expensive — it’s that each dollar is worth less, so you need more dollars to buy an item of the same value.
This is also why, when you put money into a fixed-term deposit, even though the number of dollars has gone up each year due to the interest earned and added to the principal, the value of the combined amount remains virtually unchanged.
The number of dollars is called the nominal value, and the after-inflation value is called the real value. So, the nominal value has increased by the amount of interest earned, but the real value has changed very little.
Those who don’t understand this and spend the interest thinking of it as income will eventually find that over time, even though the nominal value remains the same, the real value will go down with inflation. Therefore, even though you have the same number of dollars, you have lost purchasing power.
Now that we understand inflation let’s compare what is really happening to your cash when interest rates were 6% compared to when they are 2%.
6% interest rates had roughly 4.5% inflation.
Spending the 6% interest thinking of it as income, you would find that even though the nominal value (number of dollars) remains the same, the real value (purchasing power) has gone down 4.5% with inflation. You’re eating into the real value (purchasing power) of your capital at 4.5% per year.
With 2% interest rates, inflation is about 1.5%, so spending the 2% interest paid out will leave the real (inflation-adjusted) value 1.5% lower.
There are two things going on here.
- The real return on your money has gone down from 1.5% to 0.5%
- The nominal return on your money has gone down from 6% to 2%
The real return is what matters because having double the number of dollars when everything costs double the number of dollars is of no benefit.
When you reinvest the interest
In real terms, provided you’re reinvesting the interest, it is still going up, although by 1% less per year. Over a short period like 3-5 years, it’s not great to be earning less, but really, you were earning very little before also, only you didn’t realise it because you were counting the nominal amount instead of the real amount.
When you don’t reinvest the interest
In real terms, when you did not reinvest the interest previously, you were eating into your capital. The difference now is that you’re forced to confront that fact by drawing down some of your principal to meet those same needs.
If you had that money earmarked for a purchase, such as a house
If you had that money earmarked for a specific purchase such as a deposit on a house, then hopefully by now you realise that the lower interest rate is offset by the fact that your money is devaluing slower, so nothing should change in your strategy to continue saving into safe assets like a HISA or fixed-term deposit.
But let’s say interest rates get to a point where it is below inflation. It would be maybe 0.25-0.5% below inflation.
Over a period of 2-4 years, while looking for a property, that would be a real loss of between 0.5% and 2% total.
Any higher return is going to come with a risk of short-term capital loss. You might be lucky, and it goes above the expected return, but you might be unlucky, and it can lose quite a lot more. You should at all times expect the very real possibility of a 50% drop with stocks with a 5-7 year recovery.
You need to ask whether it’s worth it to risk a 50% loss without enough time to leave it invested to recover to save 2%.
If you didn’t have any plans for your money
If you didn’t understand previously during higher interest rate times that your money was devaluing, this is a great opportunity for you to take heed of the previous article – that if you have decades for your money to last, you will likely need to take some risk with part of your money to get a higher return for your money to last.
Stocks are at the other end of the risk-reward spectrum. Over the short- and even medium-term, there is a risk that your actual return can be much higher or much lower than your expected (or long-term average) return.
To invest in stocks, you need to be strategic in mitigating the risks by investing only as much in stocks as you can tolerate the short- and medium-term ups and downs so that you remain invested long enough for the expected returns to turn into actual returns. This makes it unsuitable for money you’re saving for a purchase within the coming few years, such as a deposit on a house.
What about high yield or high dividend stocks?
Dividends from shares are not like interest from fixed-term deposits.
The first problem is that dividends are not guaranteed. Fixed-term deposits are legal contracts to pay specific amounts on specific dates. The amount does not change based on the movement of the market. The bond or fixed-term deposit’s issuer must pay you if it can, which you can be pretty sure of with a fixed term deposit within the government guaranteed amount in a government-guaranteed bank.
Stocks, on the other hand, do not guarantee dividends. The company does not owe you dividends. When business turns bad, companies can and do cut dividends, skip dividends, or stop paying them entirely. In fact, if a company starts to go under, it must stop paying dividends – debt such as payroll and interest on loans must be paid first.
But that’s not the only problem. Another problem is that dividends are not earnings.
- Firstly, when a company sells down some assets, they often pay out the value as dividends. This means that dividends include proceeds from selling down assets. This debunks the notion that taking only dividends avoids depleting your asset base.
- Secondly, companies pay out part of their income as share buybacks, so your dividends are again not representative of company earnings.
- Thirdly, and most importantly, companies can pay out any amount of their earnings as dividends from none to all or anywhere in between. The more they pay out, the less that is retained to grow the business, so your expected growth will be reduced by the dividend amount.
You’re not actually getting more of a return with a company that pays out a higher percentage of their earnings as dividends.
So again, the idea that taking only dividends somehow avoids depleting your portfolio is incorrect.
Dividends are not earnings. And by taking your dividend and not reinvesting it, you’re drawing down from your assets, and the higher your dividend, the more you’re drawing down.
The third problem is that stock dividend yields can be high due to an erosion in stock price, and this is what happened to VHY (Vanguard Australia’s high yield fund) when they purchased BHP and Rio Tinto after the priced dropped and consequently “fit” their model of high yield stock selection, only to find the company’s value dropped much further before they bailed on it leaving in its wake a significant loss to the fund.
Stocks have a place for long term investment, but they’re not a substitute for a HISA or fixed-term deposit to get a higher yield. They are an entirely different class of investment that can go up and down significantly over the short term, and stocks with higher yields do not mitigate this risk. The share price often falls heavily in a market correction, and dividends often suffer in an economic slowdown, so if you aren’t investing for the long term, the return from higher income may be outweighed by falling value at a time when you need to draw on it.
Should I invest in REITs for income?
Since REITs (Real Estate Investment Trusts) are traded on the stock market and invest more in commercial property, they tend to behave more like stocks than direct residential property. Consequently, the value of REITs goes up and down just as wildly as the broader stock market.
Also, REITs use a lot of leverage, so in a major economic crisis, they can be hit much more severely. During the GFC, the total stock market dropped 50%, and REITs dropped much more than that at 70% globally and even more for Australian REITs. Make no mistake about it — REITs are stocks and come with all the same risks as stocks.
Where people get tripped up with REITs is that REITs are legally required to pay out at least 90% of their earnings as dividends. As a result, people see the higher dividends and think there is a higher total return, but as explained above, they are merely paying out a higher proportion of returns as dividends and suffer from the same problem as high dividend stocks.
Other higher yield products like corporate bonds and peer-to-peer (P2P) lending
Before you look at higher yield lending like corporate bonds and P2P lending, you should take note that the higher rates are a direct result of the higher risk of the investment. High yield bonds were hit hard during the 2000-2002 and 2008 downturns. RateSetter (a P2P lending platform) uses unsecured loans to get their higher rate, and in an economic crisis, loan defaults increase markedly. Such a problem has not shown up yet since RateSetter was first set up in the UK in 2009, right after the last major financial crisis, and in Australia after that. Any higher return investment will come with a higher risk. If you knowingly understand this, that’s fine, but just like shares, don’t invest in higher-yielding products without the understanding that it comes with higher risk.