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In terms of the stock market bubble – here’s the research behind low interest rates and pricing:
In this study, they broke down investors into 2 categories: one considered the choice between a risk-free asset at 5% and a RISKY asset with 10% average returns…while the SECOND group made the choice between a risk free 1% return, or a RISKY 6% return. In both scenarios, the RISKY asset pays the same 5% more…but the results were VASTLY different.
Throughout a representation of the entire US Population, as well as 400 Harvard MBA Students…low risk-free returns caused SIGNIFICANTLY more risk taking for higher-yielding investments, even though…technically…the difference in payout was the exact same. Those findings begin to normalize when risk-free interest rates are higher, even WHEN the riskier investments still pay more.
The conclusion they found was this: People form reference points for investment returns, and when interest rates drop BELOW that level…investors are more willing make riskier investments to seek higher returns.
In addition to that, if Risky returns earn SUBSTANTIALLY more when compared to a risk-free return…investors are more likely to go for it. In this case, the difference between earning 5% and 10% is DOUBLE…but going from 1% to 6% is a 5X difference…so, when viewed in proportions…it makes riskier investments seem a LOT better.
And even MORE surprising…is that yield chasing, as they call it, does NOT “diminish with education, wealth, and investment experience” – meaning, this applies to nearly EVERYONE on a broad scale, and helps explain a LOT of the market that we’re seeing today.
Simply put, when interest rates are at all time record lows…investors are more willing to make riskier investments for an even higher return, thereby boosting the valuation of the markets, and the economy. The NEGATIVE is that it also leads people to take EXCESSIVE risks that might also exceed their ability to handle it.
The conclusion here is that – IF interest go up, there’s a high likelihood that investors won’t need to take such extreme risks…and, as a result, the market might start to decline in price. Now, of course all of this is just hypothetical…and it all depends on fixed variables that we can’t always control in the real world…but, it does explain why – with low interest rates – people take more risk, and how that winds up raising the market to the point where someone like Rich Bernstein believes its a bubble.
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