How Low Can You Go?

February
01

Written by: Jon McGraw

The Bank of Japan (BOJ) dove into the negative interest rate rabbit hole last week when it dropped its benchmark interest rate to minus 0.1 percent. If you’ve been following Japan’s story, then you know the country has been struggling with deflation for almost two decades. The BOJ’s goal is to push inflation up to 2 percent. MarketWatch explained the idea behind negative interest rates:

“Central banks use their deposit to influence how banks handle their reserves. In the case of negative rates, central banks want to dissuade lenders from parking cash with them. The hope is that they will use that money to lend to individuals and businesses which, in turn, will spend the money and boost the economy and contribute to inflation.”

If the idea of negative interest rates sounds familiar, it’s probably because Europe has been delving into negative interest rate territory for a while. Several European central banks have adopted negative interest rate strategies, and about one-third of the bonds issued by governments in the eurozone offered negative yields at the end of 2015. It’s an unusual state of affairs—offering investors bonds that pay less than nothing. If investors hold to maturity, they get back less than their investment amount.

While negative rates may not be pleasing to bond buyers, U.S. stock markets were thrilled by the BOJ’s surprise rate cut. Major indexes rose by about 2 percent on Friday.

Market performance was also boosted by a bad-news-is-good-news interpretation of weak fourth quarter U.S. gross domestic product (GDP) growth estimates. According to Reuters, slower growth in the U.S. economy raised investors’ hopes the Federal Reserve would hold back on future rate hikes.

Does the Stock Market Overreact?

Some experts say it does. In 1985, Werner DeBondt, currently a professor of finance at DePaul University, and Richard Thaler, currently a professor of behavioral science and economics at the University of Chicago, published an article titled Does the Stock Market Overreact?

The professors were among the first economists to study behavioral finance, which explores the ways in which psychology explains investors’ behavior. Classic economic theory assumes all people make rational decisions all the time and always act in ways that optimize their benefits. Behavioral finance recognizes people don’t always act in rational ways, and it tries to explain how irrational behavior affects markets.

DeBondt and Thaler’s research, which has been explored and disputed over the years, supported the idea that markets tend to overreact to “unexpected and dramatic news and events.” The pair found that people tend to give too much weight to new information. As a result, stock markets often are buffeted by bouts of optimism and bouts of pessimism, which push stock prices higher or lower than they deserve to be.

In a recent memo, Oaktree Capital’s Howard Marks reiterated his long-held opinion: “In order to be successful, an investor has to understand not just finance, accounting, and economics, but also psychology.” He makes a good point.

When markets become volatile, it’s a good idea to remember the words of Benjamin Graham, author of The Intelligent Investor, who wrote, “By developing your discipline and courage, you can refuse to let other people’s mood swings govern your financial destiny. In the end, how your investments behave is much less important than how you behave.”

Weekly Fun—Think About It

“Keep your eyes on the stars, and your feet on the ground.”

—Theodore Roosevelt, 26th President of the United States