- When interest rates rise, stocks tend to fall in value because of lower future earnings.
- Higher inflation leads to higher interest rates, which do impact the stock market.
- Investors need to build a diversified portfolio to ride out declines in the stock market.
Interest rates continue to rise, causing speculation about what this will mean for the stock market. Some investors believe that higher interest rates will force the stock market lower in the short term, but will eventually lead to an economic boom.
Others fear that raising interest rates will plunge the economy into a recession and possibly a stock market crash. Let’s walk through the impact higher interest has on the stock market and what you, as an investor, can do to limit your potential losses.
What does the news mean by interest rates?
Interest rates are the amount a lender charges for borrowing money. They are a way for the lender to consider the risk they take by lending someone money. If someone is a higher risk the lender will be compensated by giving a higher interest rate on the loan.
Banks also charge interest on money lent to other banks, known as the federal funds rate. This is the basis for interest rates that consumers pay. For example, if banks charge each other 2% to borrow money, they are going to charge you, the consumer, more for the risk of lending you money and the possibility of earning a profit.
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Fed funds rate – history and current trend
In a perfect world, the Federal Reserve works to keep inflation between 2% and 3%. At this rate, the economy grows at a healthy pace, people are working, and wages are rising. But the world isn’t perfect, and depending on outside influences, inflation can go lower or higher than this target.
Currently, we are in a period of very high inflation. There are many reasons for this, including government spending, supply chain issues, wage growth, and lax monetary policy in the form of low interest rates and increasing the money supply.
The US also saw a period of high inflation in the 1970s and early 1980s. High unemployment, an oil crisis, and poor monetary policy were all factors at the time.
When inflation exceeds the target range, the Federal Reserve steps in and raises interest rates. This will hinder businesses from borrowing money to aid growth, slowing the economy down. Individuals facing higher interest rates will begin to borrow less and save more. Overall, the results of these actions will be a slowing economy and, in time, lower inflation.
The Fed may lower interest rates when inflation is lower than the target range. This will encourage businesses to borrow to fuel growth. Faster growth means hiring more workers and an increase in wages. When people have more money, companies produce more, and the economy grows faster.
Higher interest rates and the stock market
In most cases, higher interest rates mean a stock market that declines in value. This is because when interest rates rise, companies will borrow less money. The result is their earnings will grow at a slower rate than investors anticipate.
This has a ripple effect across all sectors of the stock market. For example, an investor might put their money into a technology stock, believing it will grow 12% annually. But when interest rates rise, the growth projections drop to 7% annually. Investing in a technology stock becomes riskier than investing in a bond. So this investor might think that the risk associated with a possible 7% return is too high, and so they choose to put their money into bonds instead.
If many investors do this, the demand for stocks will fall. When demand falls, stock prices also have to fall in order to find a price that investors will find more attractive.
In the bond market, bond prices rise when investors move money into this sector, but yields will fall since they have an inverse relationship.
The most important thing to remember as an investor is that not every stock will fall just because interest rates are rising. Some stocks perform well during times of rising interest rates. Additionally, stocks with strong balance sheets and a well-defined revenue stream may only feel minimal impacts.
An intelligent investor has to look at the whole economy and see what is happening. Assess the rising rates and then determine what investments make the most sense.
Building a resilient portfolio
Times of high interest rates are bound to happen during your investing life. The key is building a portfolio that allows you to best handle the volatility that comes along with higher rates.
Here are a few things to keep in mind when constructing your portfolio:
- Diversify your holdings across different asset classes. This will ensure that you have other investments to rely on if one sector is struggling.
- Choose quality over quantity. It’s better to have a small number of high-quality stocks than many low-quality ones.
- Understand how comfortable you are with risk. When you take on more risk than you are comfortable with, you set yourself up to lose more money and risk making emotional decisions, like selling out of the market, that will have considerable negative consequences on your long-term wealth.
- Know your investing goals. Knowing why you are investing will help you to get through a falling market. This is often measured in time (short-term, long-term, etc).
- Monitor your portfolio regularly and rebalance it when necessary. This will help you stay on track and avoid making impulsive decisions.
- Have cash on hand. It is always wise to have a small allocation of cash to invest in the market when it falls. This allows you to buy stocks ‘on sale’ and enjoy a significant gain when the uptrend resumes (also commonly called ‘buying the dip’).
When it comes to investing, there is no one-size-fits-all approach. What works for one person might not work for another. The most important thing is to have a strategy you are comfortable with and believe in.
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The last thing you want to do as an investor is get scared and sell out of your holdings. Have an investment plan that identifies your investment goals, time horizon, and risk tolerance, and you should be able to weather any storm that comes your way.
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