Unless you’ve been hiding under a rock you’ve noticed that interest rates have been increasing for a while now. What fewer people know is why the rates are rising and what impact this has on their investments.
Let’s start with why. Though the reasons are a little more complicated than this, generally, the Federal Reserve is charged with helping the U.S. economy avoid excessive unemployment and excessive inflation. These two are seen as two ends of a spectrum. If the economy is doing poorly unemployment goes up; if the economy is growing too quickly inflation goes up. Though several other factors lead to both unemployment and inflation, the two are rarely seen together as in the 1970’s when the U.S. experienced “stagflation”. So when the U.S. is leaning toward high unemployment, the Fed uses its toolbox to try to boost the economy, and when the U.S. is leaning toward high inflation, the Fed uses that same toolbox to try to slow down the economy. One of the main tools they have is the Fed Funds Rate, which directly impacts interest rates in the U.S.
All of that to say, right now the Federal Reserve believes the U.S. economy is growing, and may be starting to grow fast enough that inflation is becoming a bigger worry than unemployment.
So what does this mean for you?
There are three main ways to “invest” your money: savings or money market accounts, bonds, and stocks. I also consider education and real estate investments, but those are more non-traditional, so we’ll discuss those some other time.
Traditional savings accounts should see their interest rates increase when overall rates increase. If they don’t then you have your savings with the wrong bank. I know it isn’t exciting, but everyone should have a boring savings account for their emergency fund, and you may as well get paid a little for keeping your money with the bank. Ally and CapitalOne tend to have among the highest interest rates and both are easy to work with.
Bonds have an interesting relationship with interest rates. The higher the interest rate, the more attractive bonds are, but as interest rates go up, the value of existing bonds goes down. Wait, what? Let’s say you have a 10-year bond paying 3% interest, and a new 10-year bond becomes available that is identical except it is paying 4%. Now if you wanted to sell your 3% bond it’s value has gone down because buyers can now get a bond that’s paying higher interest.
Now the confusing part...if you hold the bond to maturity, that decrease in value doesn’t matter. You will still be paid the face value of the bond at maturity. We’ll cover how bonds work in more detail later, but this is an important point to understand so I’ll repeat. The change in a bond’s price on the secondary market doesn’t impact the value of the bond if you hold it to maturity.
So in a rising interest rate environment, you should expect the value of bonds on the secondary market to go down.
Stocks are fickle, and any individual stock is impacted more by the situation at the company than by what is going on at a macroeconomic level. Now for each company, the impact of a rising interest rate may be one of several things.
Lower profits - Rising interest rates decrease the amount of money consumers have available to spend, and this could lead to lower profits for companies that sell goods or services considered discretionary.
Higher Profits - As with any transaction there are two sides to the interest rate transaction. As interest rates increase, banks and other financial institutions will see increased profits, as will companies that sell low-cost alternatives to the above discretionary products or services.
More Expensive Borrowing - If a company needs to borrow money for a project they either need to borrow from a financial institution or investors, both of which will ask for a higher interest rate to lend the money. This means fewer projects will be done, or the projects will be scaled back.
“Flight to Growth” - You’ll often see financial commentaries about the “flight to value” or “flight to stability”, but the opposite also happens. Some investors will move to a higher equity allocation to combat higher inflation and the devaluing of bond portfolios in a rising interest environment.
The Unknown - When a company has a major setback, like a very public lawsuit, or an off-color tweet from the CEO, or a viral video that casts them in a bad light, the stock falls. When a company has an unexpected breakthrough or endorsement, the stock rises. This is what swings a stock price the most wildly. Most investors have known that interest rates were going up this year and that was baked into stock prices as soon as the information became available. Therefore, it’s the things investors don’t know that change stock prices on a daily basis.
Herd Mentality - Finally, there’s the “wisdom” of the herd. When most of the market is buying, stock prices go up, and when most of the market is trying to sell, prices fall. What gives the herd its mentality? If I could answer that I’d be making so much money off the stock market that I wouldn’t be writing this. In fact, anyone that could accurately predict that would keep it to themselves so the market would continue to behave the way they predict. As soon as the market is told its expected to behave a certain way, that becomes built into market prices.
So what should you do?
Well, if you have a portfolio allocation that is based on your risk profile, stick to it. If you don’t have an appropriate portfolio allocation, find out your risk profile and change your allocation so it is one you could leave alone, even if it experienced the largest losses the allocation has experienced. An all-stock portfolio invested in only the S&P 500 would have lost 35% of its value in the last 6 months of 2008. So an all-stock portfolio isn’t appropriate for you if that much loss causes you to lose sleep, or worse, to have to change your financial goals.