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Is Investing in Safe Assets Safe?

Koichi Ando
Professor, Faculty of Law, Chuo University
Areas of Specialization: Economics and Finance Theory

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As our society ages, I think more and more people wish that they could steadily increase the value of the assets they possess and create a future for themselves in which they can live with peace of mind. Nevertheless, it is surprisingly difficult to achieve this with safe assets. This is partly due to changes in the investment environment as a reflection of the implementation of aggressive monetary policies and a faltering growth engine, but it is actually fairly hard to consider what is safe or what is certain. Unless you think carefully, you will be pulled down by the undertow. In this column we will take a fresh look at what investing in safe assets (especially bonds) means.

Tendency to focus on safe assets

Common knowledge when it comes to finance is that financial assets can be divided into safe assets and risk assets, and that by combining both types in a portfolio, you can select the combination of risk and return that suits you. To increase returns, you need to be willing to take on risk. And by diversifying your investment in risk assets, you can aim for the same returns but with a far lower level of risk. Bonds are the classic example of a safe asset, while shares are the classic example of a risk asset.

Yet, for example, because the goal of investing in private or corporate pensions, which are for living expenses, is to secure the necessary funds to ensure a certain standard of living, you cannot afford to take on much risk, even though you want to earn a certain level of return. If the value of your pension has dropped significantly when you start receiving it due to bad timing, you will not be able to afford to live a long life or to get sick. You will not be able to live with peace of mind, so you will secure funds for savings, even though it is tough to do so, and employ a sensible investment approach whereby you invest mainly in safe assets. A fair number of people think in these terms.

One of the characteristics of investment in Japan is that a lot of people believe that the sensible approach is right, that you should do your utmost to avoid taking on risk, and that you should therefore park your money in so-called safe assets. This is not only limited to pensions, but also to spare cash. For institutional investors, too, government bonds and other sorts of bonds make up a large proportion of the financial assets they hold. Shares and other risk assets account for only a small percentage.

Safe and certain investment?

However, this sensible approach of investing in safe assets is actually not easy to implement. Safe assets seem to be generally regarded as assets where the principal is guaranteed and that carry fixed interest. The thinking goes that keeping cash is unwise, but that government bonds, for example, are appropriate choices because the volume in circulation is large so they can be bought and sold easily and because their issuers have strong credit standings.

With such investments, the principal amount of the asset as it appears in accounting books remains unchanged. The only increase is the interest. But according to economic theory, these are nothing more than nominal amounts. The satisfaction and pleasure (which in the language of economics is referred to as “utility”) gained from various types of consumption is not based on monetary amounts. The value generally differs from the monetary amount in the accounting books, so in effect it cannot be said that these investments are safe and certain. In the discussion that follows, I will explain these two issues in an easy-to-understand way.

Impact of inflation/deflation

One is fairly straightforward — the issue of the value of money. What you are aiming for so that you can use money for consumption in the future is not a certain monetary amount (which is also described as the nominal amount). What you want to be safe and certain are the economic and material benefits that accrue to you from spending the money. For example, you want to eat so and so many grams of rice each day, or you want to live in a home of this or that size. The degree to which you can achieve these goals will depend on the prices of goods at the time you use the money.

In the long run, one neo-classical economic theory (which is a relatively standard theory) states that the nominal interest rate is determined by the real growth rate (the real interest rate) which reflects the quantitative growth rate, and the inflation rate (the rate of increase in the prices of goods) which is affected to some extent by the rate of growth in the money supply. How accurate is this? Strictly speaking, the theory is slightly doubtful, but at the very least it is said that over the medium to long term, if the inflation rate changes, the interest rate (the nominal interest rate) in each year may reflect that.

This means that if the rate of return on investment far into the future is determined by fixed interest payments, you will not be able to benefit from the stable interest rates (compared with interest rates which change in response to economic conditions, you could be better off or worse off, so your situation is unstable). Because of this, so-called safe assets are not free from demerit, at least in this respect.

Determining the value of assets

The other issue is a little more complex. It is related to the value of the assets you have invested in — their market value or their potential value if sold, i.e. how much you would get for them if you were to convert them into cash right now. This is not the nominal amount, and could be described as their real, economic value (this reflects the difference between book value and actual value, and is separate from the previous discussion on inflation and deflation). The method for calculating this is simple, but it is regarded as most accurate to discount the amount of money that the asset is expected to generate in the future (or in specialist terms, the cash flow) by a certain discount rate in order to convert it to its present value. If the money is going to be received in the distant future, it needs to be discounted over and over again.

Let us assume, for example, that it is possible to lend or borrow unlimited amounts at an interest rate of 5% per year (in other words, we are assuming that financial markets are functioning perfectly). With this approach, if you are going to receive and be able to spend 1.05 million yen next year, it is the same as being able to spend 1 million yen this year (because you could borrow and spend the money now and repay it later with interest). The present value can therefore be calculated using the formula 1.05 million yen / (1 + 0.05) = 1 million yen. This is referred to as the discounted present value, and is the standard method for determining economic value. The method allows us to accurately identify the amount of money that can be used for consumption at the time the asset is valued (note that whether this amount can actually be obtained by selling the asset to convert it into cash is a separate issue, and it can be said that you can obtain the very information required to make such a judgment).

The problem of the timing of conversion into cash and consumption

Taking the knowledge we have acquired above, let us step up our mental workout and compare two methods of investing 1 million yen for two years. With the first method, you purchase long-term bonds (fixed interest), while with the second method, you purchase short-term bonds (variable interest). However, you do not know whether you will convert the assets into cash and use the cash for consumption at the end of the first year or the end of the second year. (We will also assume that there is no inflation or deflation, choosing instead to focus on issues other than this.) The two investment methods can be summarized as follows:

  • Investment method 1: Purchase long-term bonds, generally hold them to maturity, and receive interest at the end of each year
  • Investment method 2: Purchase short-term bonds, purchase short-term bonds again at the end of the first year, and receive interest at the end of each year

The interest rate for the first year (variously also referred to as the cost of capital or the discount rate) is determined to begin with, but the interest rate for the second year (the same as the interest rate on short-term bonds) will not be determined until the start of the second year. This is a natural assumption that if we are in the first year now, we do not know what is going to happen in the second year (i.e. in the future). We will assume that the interest rate is 3% in the first year and 2% or 4% in the second year. We will also assume that the coupon rate (i.e. the interest paid as a proportion of the principal), which is the rate of interest on long-term bonds, is 3%. (We will also assume that when the bonds were issued via auction, they were all sold at face value, i.e. for 1 million yen.)

Investment method 1: Long-term bonds, fixed → end of second year is certain
Figures in accounting books Initial First year (end) Second year (end)
Principal 1,000 1,000 1,000
Interest (long-term fixed) - 30 30
Economic value Initial First year (end) Second year (end)
Income (certain) - 30 30
Asset value (uncertain) 1,000 1,010 or 990
(uncertain)
1,000
(certain)
Investment method 2: Short-term bonds, rolled over → end of first year is certain
Figures in accounting books Initial First year (end) Second year (end)
Principal 1,000 1,000 1,000
Interest (short-term, varies) - 30 20 or 40
Economic value Initial First year (end) Second year (end)
Income (uncertain) - (Certain)
30
(Uncertain)]
20 or 40
Asset value (certain) 1,000 1,000 1,000
Note 1: Figures for discounted present value have been rounded off to the nearest whole number.
Note 2: To keep the explanation simple, interest earned on interest (compound interest) is not taken into account.

Note 3: Figures are shown in units of 1,000 yen.

With the first investment method, which has traditionally been regarded as constituting investment in safe assets, the principal of 1 million yen is reimbursed at the end of the second year, and fixed interest of 30,000 yen is paid at the end of the first and second years. But if you want to spend the money at the end of the first year, the amount you can spend is either 1.02 million yen or 1.04 million yen, which is uncertain. This uncertainty is due to the effect of the level of the interest rate in the second year. If the rate of return on short-term bonds in the second year is 2%, the discounted present value will be 1.03 million yen / 1.02 = approx. 1.01 million yen, but if it is 4%, the discounted present value will be 1.03 million yen / 1.04 = approx. 0.99 million yen.

With the second investment method, meanwhile, the interest you receive at the end of the second year is uncertain, so if you want to spend the money at the end of the second year, the amount you can spend is uncertain. If you want to spend the money at the end of the first year, however, the amount you can spend is fixed at 1.03 million yen. In terms of present value, this is because 1.02 million yen or 1.04 million yen will be paid at the end of the second year when the rate of return on short-term bonds is 2% or 4%, respectively, so both initially and at the end of the first year the value of the assets themselves are stable at 1 million yen. So if, for example, you always want to maintain a certain amount to prepare for unexpected events, this is one way of doing it.

Which investment method is safer and more certain ultimately depends on when you wish to use the money for consumption. If you are going to use it at the end of the first year, the second method is more certain, but if you intend to use it at the end of the second year, the first method is more certain. This means that if you have not decided when you are going to use it, you cannot achieve safety and certainty. Note that if we apply the same approach to longer timeframes, you can see that the second method is vastly superior for keeping the value of our assets stable.

One solution: Investing your money in physical businesses

With regard to the two issues, I think you will have understood that in reality it is not easy to secure what could be described as safe assets. Another thing I want to emphasize is that whether you are an individual or a company, there are limits to what you can do within the confines of financial assets.

One solution to the difficulties of investing that I have been discussing might be to secure physical assets that generate a relatively stable level of economic value each year. In the case of individuals, an obvious example would be to focus on the pay for work, which is also described as a human asset, while in the case of companies, an example of this would be to focus on the money you earn from actual operations, which involve the utilization of land, buildings, and equipment. The former suggestion might leave you feeling a bit disappointed, but specifically, it refers to education and training (investing in yourself!), whereas the latter refers to directing money into things like R&D and plant and equipment. Even if you invest money that you cannot find a good use for in financial assets, if you are aware that investing in yourself or your company is going to produce better results, and that you yourself can make such investment decisions better than anyone else can, that is going to be the superior path to follow.

Looking at things in this way, we cannot say that businesses such as banking, which mainly involves lending to real businesses, and the investment business, which involves investing in shares directly related to actual business performance, are not safe. To some extent, we need to rethink the meaning of safe assets for investment. If you still want to pursue complete safety in economic terms, you at least need to realize that investing only in financial assets such as government bonds still carries a certain degree of risk despite how they may appear.

Koichi Ando
Professor, Faculty of Law, Chuo University
Areas of Specialization: Economics and Finance Theory
Professor Ando was born in 1968 in Ehime Prefecture. He graduated from Aiko High School in March 1987, and the Faculty of Economics, the University of Tokyo in March 1991. In April 1992 he joined the Development Bank of Japan. After working in sales at a branch of the bank, he was dispatched to the Economic Planning Agency, after which he returned to the bank, where he worked first in departments such as research department and later at the Research Institute of Capital Formation. In March 2005 he completed a course of study at the Graduate School of International Corporate Strategy (ICS), Hitotsubashi University, obtaining a Financial Strategy MBA. In March 2009, he obtained a Ph. D. in Economics from the Graduate School of Economics (Financial Systems), University of Tokyo. He has been in his current post since April 2013.