Investing & The Fed: How Will My Investments Be Impacted?
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Whispers abound that the Fed intends to lower interest rates. Even a hint of declining interest rates can cause the stock market to rise. Learn about how interest rate movements can impact your investments.
Investing is both science and art. One can do everything right and still watch their investments fall. That is because as much as we might believe to the contrary, investors are not completely rational. Read any behavioral finance book and you will see multiple examples of investor stupidity. Remember the dot-com bubble bursting in 2000? What about the mortgage melt down a few years later? Many investors bought into the stock market after a big run up or sold at the bottom.
In fact, abundant research shows that investors tend to buy as stocks are hitting market peaks – submitting to following the crowd. And after a market drop, many investors get scared and sell, near market bottoms. Buying high and selling low isn’t the best way for investment success.
Interest Rates Influence Investment Returns
When the Federal Open Market Committee meets and its Chair, Jerome Powell reports to the country, all the investing markets listen, and react.
Some have mentioned that the Chairman of the Fed is the most important person in the country. (Even more influential than the president!)
So, if the Fed announces that they will cut interest rates, how will that impact individual investors? What if they mention raising the Fed Funds Rate (the lending rate they charge member banks), how might that impact investors?
Interest Rates Influence Investment Returns
Any certificate of deposit or bank savings account holder can verify that low interest rates stink for savers. Just take a look at the less than 1 percent rate return on your savings. When interest rates increase, so do the returns on your cash accounts. Heck, even when the Fed chair mentions lowering interest rates, the markets inch upwards.
Higher interest rates are wonderful for savers. When interest rates go up, you can lock in higher CD rates, Government I bond rates, and even individual corporate bond rates.
Current bond fund holders be aware of rising interest rates.
There is an inverse relationship between bond prices and interest rates. That means, when interest rates go up, the value of your bond fund goes down.
My father-in-law called me as interest rates were rising, and his bond fund dropped in value.
I explained that as interest rates were likely to continue moving upwards, the value of his bond funds will fall. The reason for this is because investors can get higher yields in the marketplace. Thus as interest rates rise, investors will pay less for lower yielding bonds, and thereby the principal value of bonds and bond funds declines. Although as the fund purchases newer bonds, with higher coupons, the bond fund’s yield will rise.
If you hold individual bonds, even if the bond value goes down, you can hold the bond until maturity and get the face value for an individual bond.
Shorter term bond funds, those funds holding bonds that will mature within the next year or two will fall less than those funds holding longer term bonds, when interest rates rise.
What Happens to Stocks When Interest Rates Rise?
Historically, the stock market prefers lower interest rates. One of the reasons is because companies can borrow money more inexpensively when rates are low and thus can grow more rapidly.
This does not always hold true. There are periods when interest rates were relatively high and the stock market advanced.
With the recent increase in interest rates, the strong economy and stock market continued to advance.
Actually, several years ago, when this article was originally published, I suggested that as interest rates rose, we might be due for a stock market correction. I was wrong! The stock market continued to go up!
What Happens to Stocks When Interest Rates Fall?
Now that interest rates might be lowered, I won’t even begin to predict what will happen with the stock market. Typically, the equity market favors lower interest rates.
Yet, at the end of a 10-year bull market, it’s tough to predict what will happen next in the investment markets.
I’m not brazen enough to predict the future direction of the stock market. Despite the long bull market, markets could continue rising.
Here’s what I suggest, regardless of whether interest rates rise or fall…
Keep a Diversified Asset Allocation – Always
Set up a diversified asset allocation. Invest in stocks, bonds, cash, and real estate in proportions related to your risk tolerance.
With a diversified portfolio, even if the stock market falls, you’ll own other assets, like bonds, cash and real estate, that will cushion the negative impact. And if you have debt, even if you’re stock market investments are rising, you’re still losing. So pay off your debt.
In general, investing history recommends choosing a reasonable asset allocation, in line with your risk tolerance and sticking with it.
After all, no one can successfully predict the future. Whether the Fed raises or lowers interest rates, there are no guarantees how the stock market will react.
The best investors continue to invest, in all market conditions. Ultimately, if global businesses continue to grow, so will your stock market investments, over the long term. In the short run, no one knows what will happen with the investment markets.
Note: This article originally appeared at Barbara Friedberg Personal Finance.
Category: Stocks
