Behavioral Finance

The Psychology of Safety

Why would anyone accept negative interest rates?

by Herbert K. Daroff, JD, CFP

Mr. Daroff is affiliated with Baystate Financial Planning, Boston. He is a contributing editor to Life & Health Advisor Magazine. Connect with him through e-mail:

The first in a series of opinions on the emergence of ‘negative interest rates,’ a central bank strategy for the issuance of new Government Bonds that began in Europe in 2014 and appears to be migrating to the U.S., designed to stimulate stagnant economic activity.

Why would anyone accept negative interest rates? In order to answer this question, let’s explore a bit of behavioral finance.

First, people’s dismay over loss is much greater than their joy over gain. Most feel good about a 5% to 10% increase in their portfolio, but are petrified when their portfolio value goes down 5% to 10%. Second, people’s investment decisions are more strongly motivated by fear than greed.

A few years back, I believe it was the T. Rowe Price Asia fund was up about 90% for the year. Yet, the many of the investors in that fund lost money. How can that be? Most investors got in late in the year after the media began reporting on its performance. By then, it was up some 95%, but it closed up about 90% for the year. That’s investing motivated by greed, but they got in too late.

Investment decisions motivated by fear are much stronger, especially by the more risk averse investors. Portfolio managers want to BUY when prices have declined (a down market), but they cannot do so because as investors flee, the managers need to SELL in order to cover the liquidity needs of fearful investors who think that the sky is falling.
One of my colleagues said, “The stock market is the only market in the world that has people running OUT of the store when prices go down.”

Why do retirees buy fixed annuities? They are assured of earning positive interest, but are nearly as assured of reducing their standard of living, net after inflation. With today’s low interest rates, this is a great time to lock in a mortgage loan, not to lock in fixed income.

So, why are fixed annuity sales booming? Fear of running out of money. Fear of losing principal is stronger in most people than fear of losing purchasing power. Yet, as financial planners, we recognize that losing purchasing power is a far greater threat to a retirement income strategy.

Are banks still safe?

But, if fear of losing principal is so strong, why accept negative interest rates? Your $10,000 will be $9,950 with a 0.5% negative interest rate. Why not just take the money out of the bank and put it into a “safe” place? That’s the key. “Safe” place is the bank.

The fear of having the money stolen, leaving a safe place, is greater than the fear of losing principal.
Some investors have already experienced negative returns in seemingly safe investments. Government bonds, in some countries, have been purchased at a premium. In my limited research, I found one corporate bond, Nestle, as well. Even some money markets in the U.S. have experienced decreased values from one period to the next.

I have purchased Israel Bonds and, in some cases, chosen not to redeem them, such as during one of the many conflicts, like the 6-Day War. For other than investment reasons, I made a gift to the State of Israel. Quite a few new clients have multiple U.S. Savings Bonds that have stopped earning interest years ago. Some of that is simply neglect. But for others, they chose to make a gift to the U.S. Treasury, like during Vietnam or Desert Storm.

How do you know if you are a risk-averse investor? Answer this question. If you buy a stock for $10 and sell it for $12, but shortly after you sold it, the stock price increases to $15, in your mind, did you MAKE $2 or LOSE $3?

With the DJIA going from 18,351 to 15,370 (52 week high and low as I am writing this article), some would rather have 0.5% negative interest in the bank than lost 16%+ in a few weeks or months in the stock market. They would rather lose 0.5% at the bank than risk losing all of their money if left in shoe box at home and then were robbed. NOTE: This might be a good opportunity to invest in companies that make and install built in safes, bolted to the foundation or structural supports, for the home and office.

Safety vs. Loss

Safety appears to be a stronger behavioral emotion than loss of value, resulting in people accepting negative interest rates. Clearly, people are willing to pay for safety.

Why do investors pay investment advisors a fee for assets under management? The media pundits tell them to buy no-load index funds. But, which indices should they choose and how much of their portfolio should be allocated to which index? They pay for management hoping that the investment advisor makes better choices for them than they would make for themselves.

I’m willing to pay the fees for the living benefits in my variable annuities. A portion of my retirement income is still compounding based on an 18,000 point DJIA because I was able to lock in the value near the peak.

Suppose I was able to lock in the actual 52-week high. My income base at the end of the year would be 105% of that 18,351 point mark (equals 19,268), or even higher. That’s better than having my income based on 15,370, higher or lower. In an up market, people feel that they wasted the extra fee they were willing to pay for safety.

But, they certainly appreciate the value they receive in exchange for that fee in a down market. Do you feel that you wasted your fire insurance premium, just because you didn’t have a fir? You pay the premium in case you do have a fire. The more risk averse you are, the more willing you are to pay a fee for safety.

Today’s Risk-Aversion

Life insurance cash values in fixed (not variable) products also increase from year to year, provided you pay the premium, or have paid a sufficient number of premiums to cushion against loans used to pay premiums. Limited pay whole life products are designed to experience positive returns on cash value, assuming that you pay all 10 or 20 premiums, for example.

How do you know if you are a risk-averse investor? Answer this question. If you buy a stock for $10 and sell it for $12, but shortly after you sold it, the stock price increases to $15, in your mind, did you MAKE $2 or LOSE $3? If you answered, MADE $2, then you are a risk-averse, or conservative, investor. If you answered LOST $3, then you are a more risk-neutral, or aggressive, investor. If you are not really sure if you MADE $2 or LOST $3, then you are a more moderate risk taker as an investor.

What is my advice to the risk-averse investors who might be ok with negative interest rates? Pay down more of your mortgage rather than lose money in the bank. That’s a positive interest return. However, for the rest of the investors, why pay down a mortgage at these low, and mostly deductible, interest rates?

Unless, that is a better recourse that accepting even lower bank interest rates, let alone, negative rates. Rather than suffer negative interest rates, look at improving your debt service. But, if you do, be sure to have a home equity line of credit (HELOC) just in case you need the funds for an emergency. ◊