Low-Rate Environment Could “Kill” Stock Market

A recent study shows that, when rates are low, investors’ appetite for risk “increases beyond what seems logical,” according to an article in The Wall Street Journal.

The article argues that the average yield on the 10-year Treasury of 2.35% fuels this “behavioral quirk,” keeping share valuations high. “The stock market is rich by just about any valuation measure,” it says, “and by some excessively so.”

For the study, the researchers created two investing scenarios. The first represented a 5% risk-free rate of return and a 10% expected rate of return from a “risky” investment, such as equities. The other offered a risk-free rate of 1% with a 6% risk-asset return. Study respondents said they would invest “far more in the risky asset when rates were low,” according to the article. The researchers then ran another experiment in which they told participants they would get paid “based on the success of their hypothetical investment,” for which the findings were the same.

The article explains the behavior this way: “One reason is that people who had long earned 6% returns were willing to take more risk to reach that number. The more investing experience the people had, the more likely they were to take on more risk in the low-rate environment,” concluding that if rates rise and investors revert to less risky portfolios, equities could “be in for a big drop.”