The marshmallow test is a classic of standardised psychology. A young child is given a marshmallow, and told they can eat it whenever they like. Wait for 15 minutes, though, and they can have two. Then they are left alone. When the test was first performed, at Stanford University in the 1960s, the average child succumbed in three minutes. But those who did not were rewarded with more than just a sugar rush. A follow-up study in 1990 showed that success on the test was associated with a whole range of goodies in later life, from academic achievement to coping better with stress.
By now, the associated investment lesson is eye-rollingly familiar. Jam tomorrow should be prized over jam today. Valuing a firm by its present earnings, assets and dividend yield is for the dinosaurs. The pace of technological innovation has made these metrics obsolete; instead, what matters is a company’s chance of explosive future growth. For the canonical example look to Amazon: unprofitable for decades, now the world’s fifth-largest company. To their proponents, the beating growth stocks have taken over the past year simply does not matter. Truly innovative, disruptive firms will eventually provide returns that make any number of temporary setbacks eminently bearable.
Such thinking has guided some of the most successful investors of the past few decades. Yet their strategies have played out during a 40-year period in which interest rates have mostly fallen. Should that trend now reverse—and the Federal Reserve seems set to raise rates by three-quarters of a percentage point for its third meeting in a row on September 21st —the logic will be turned on its head. In a world of higher interest rates, waiting for jam tomorrow just isn’t worth it.
To see why, first consider a crucial driver of this year’s downturn. In place of current profits, growth stocks offer the prospect of bigger ones in the future. But a dollar in ten years’ time is not worth the same as a dollar today, because the dollar today can earn income in the meantime. At an interest rate of 1%, you need to deposit $91 to have $100 in ten years’ time. At a rate of 5%, you can deposit just $61. Hence this year’s fall in growth stocks: as rates have risen, the promise of future profits has become worth considerably less in the present.
This logic has broader implications than most investors realise. Now imagine you will receive $100 a year, for ever. By the reasoning above, this has a finite present value, since compound interest means payments in the distant future are almost worthless. With interest rates at 1%, the payment stream is worth $10,000; at 5%, it is worth $2,000. But as well as reducing the value, the higher rate also changes the distribution of that value. With rates at 1%, less than a tenth of the stream’s value comes from payments made in the first ten years. At 5%, around two-fifths does.
In other words, higher interest rates dramatically alter firms’ incentives when choosing which timeline to invest over. Sacrificing short-term profits for longer-term gains is one thing when you are trying to persuade investors that your superapp, machine-learning algorithm or gene-sequencing widget has the potential to up-end an industry. It is another when even the best-case scenario has its value so heavily skewed towards what can be done in the next decade. Startup founders are used to shaking off derision over implausible, Utopian dreams. It is more of a kick in the teeth to realise that even Utopia is not worth much unless it can be achieved in short order.
Nor are the implications limited to early-stage firms, or even to the stockmarket. Should profits be reinvested in a project that may not make returns quickly enough to be worthwhile, or should they just be returned to shareholders as a dividend? Should a company with callable bonds and cash to spare bother repaying? Is there any point in a fixed-rate mortgage-holder overpaying, just to reduce future payments whose value has already fallen?
The original marshmallow test, it turned out, had a flaw. Exclude some children from better-off families (which seems to make them both more willing to delay gratification and more likely to succeed in later life) and much of its predictive power suddenly disappears. Investors who have spent the past few decades betting on long-term, world-changing disruption were similarly fortunate. It was not that they were wrong to be so optimistic. But in falling interest rates, they got a helping hand that is now being withdrawn.
Read more from Buttonwood, our columnist on financial markets:Emerging-market stocks are struggling in an intangible world (Sep 8th)Why investors are reaching for the astrology of finance (Sep 1st)Investors are optimistic about equities. They have no alternative (Aug 18th)
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