"Idiocy of the masses"​ or "masses of idiots"​?

“The market can stay irrational longer than you can stay solvent” is a much used and abused market saying. It is often employed when pundits perceive that some actions by investors are irrational in the face of data. However, being irrational can sometimes be the “rational” thing to do for investors.

I recently pondered the long-term outlook for government bonds. For years, I have been wondering, why investors keep investing in these assets despite their extremely low yields. If you buy a 10-year Gilt today and hold it to maturity, the total return will be around 1.2% per year, way below the going rate for consumer price inflation in the UK of 2.4% or the 10-year expected average retail price inflation of 3.3%. 

The situation gets worse for investors in government bond portfolios that try to match an index, which essentially means keeping the duration of the portfolio within a narrow range. The modified duration of the current on-the-run 10-year Gilt is 8.8, which means that an upward shift of the yield curve by 1% will lead to a loss of 8.8% in a portfolio with that duration. In other words, a small rate move can destroy more than seven years of return. 

Given that the current yield of Gilts and government bonds around the world is so low, the odds of lower yields in the future are much lower than the odds of higher yields, so why would any rational investor hold government bonds in her portfolio? They may think that with the right adjustment path it will still be possible to beat inflation with government bonds by reinvesting coupon income at a higher yield, but I have shown years ago that this is practically impossible.

Institutional investors typically argue that they need to invest in long-dated government bonds to match the duration of their liabilities and neutralise interest rate risk in an asset-liability context. But with interest rates close to zero, there is an opportunity to improve the funding ratio of an existing pension fund. If a pension fund stops investing in long-dated bonds and interest rates rise, the present value of the liabilities will decline substantially but the value of the assets will not. Hence, the funding ratio increases. On the other hand, if interest rates stay low or decline a little bit more, the present value of the liabilities will increase while the present value of the bond portfolio will not. However, if the long-dated bonds are replaced by equities or alternative investments, chances are that lower interest rates will boost the returns of these asset classes and limit the decline in the funding ratio.

The seemingly rational thing to do for institutional investors would be to reduce their holdings of government bonds and reduce the duration of their bond portfolio dramatically, yet practically no institutional investor is doing that. The irrational thing to do is to invest in bonds with practically no return and lots of downside risk and that is what most institutional investors continue to do today.

It seems as if we are facing an “idiocy of the masses” but in my view, we are simply facing a “mass of idiots” and that is a crucial difference. If an investor faces a mass of idiots that is large enough to drive the overall market, the rational thing to do is to join the mass, no matter how stupid that may seem. Assume you run a pension fund and you have long-dated liabilities. If you choose to stray from the herd and reduce the duration of your fixed income portfolio you might become a hero if interest rates rise but face career risk if they drop. 

But if instead you do the same thing as everyone else does, you not only have reduced your career risk, but more importantly, you might have eliminated your downside risk altogether. If interest rates rise and the majority of institutional investors face sinking funding ratio (due to declining equity returns in reaction to rising rates, for example) the problem for the pension system quickly becomes systemic. And as we have learned during the Global Financial Crisis, once an economy faces a systemic risk, the government and central banks are quick to bail out the troubled investors. Hence, your decision to keep holding long-dated bonds becomes a “heads, I win, tails the central bank loses”-position. 

These kinds of “moral hazards” are surprisingly common in our economy today. Take the mortgage market. In the UK, the majority of mortgages are floating-rate mortgages so that homeowners are directly exposed to rising interest rates. The way to protect yourself from the risk of rising rates is to invest in a fixed rate mortgage, but they tend to be more expensive. Instead, one can continue to hold floating rate mortgages, hoping that as long as enough people do the same, the central bank simply cannot hike interest rates too quickly or too much because it would immediately trigger a nationwide credit crunch. The “masses of idiots” in this case restrict the policy leeway of the central bank.

Or think of retirement savings. In practically all developed countries, private households save too little for retirement and face significant declines in income, once they retire. Personal finance specialists thus rightfully encourage people to save more for retirement. But if enough pensioners face poverty in retirement, the government has a strong incentive to help them out of their misery by increasing pensions from an already underfunded pension system. Then who is going to look stupid? The ones who saved more during their working years or the ones who spent their income and then relied on a government bailout during retirement?

Finally, doomsday prophets tend to mention the massive deficits of the US as a highway to hell. Combine the already large mountain of debt in the US with unfunded liabilities like social security and you get a debt/GDP-ratio that in the case of the US surpasses 1,000%. What happens if the US can’t pay those liabilities? Well, the one thing that seems least likely to me is that the US would default on its debt or investors would sell government bonds in large quantities. A default on US Treasuries would cause a global economic catastrophe and everyone knows that. So investors, both foreign and domestic continue to buy Treasuries, no matter the risks associated with them. And the longer they buy Treasuries, the bigger the debt load of the US becomes, and - ironically - the less likely a US default becomes.