Low Interest Rates Don't Build Wealth

January 16, 2014
Insights

In investing circles low interest rates are celebrated because they drive asset prices higher. We all feel wealthier (not to mention smarter!) because the market value of our house, shares or retirement savings 

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 our nest-eggs are to provide for the long term needs of ourselves and our love ones. Our intrinsic spending needs are spread into the distant future.

In this sense low interest rates don’t help at all. Though the ‘net present value’ of your investment might have increased, if the expected cash flows from our investments haven’t changed, the ability of your  investments 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.

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.

Interest rates movements are mostly a distraction for investors, they don’t build real long term wealth. When investing we’re better off focusing on profits, cash flows and dividends, rather than interest rate driven price movements.