How does a rise in interest rates impact my portfolio?

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Welcome to Select’s new advice column, Get your money right. Once a month, Financial Advisor Kristin O’Keeffe Merrick will answer your pressing financial questions. (You can read his first episode here on what to do with your excess cash.) Do you have a question? Send us a note at [email protected]

Dear Kristin,

I’m a little rusty on my economy. I would like a refresher on why a rise in interest rates could potentially impact my equity portfolio. Can you explain?

Sign,

Rusty in Ridgewood

Dear Rusty,

This is a big question and an important question. Let’s first talk about “interest rates” in the general sense. Why are they important?

Interest rates determine the level at which we can borrow or lend money. Think of it in terms of mortgage rates: even if rates are low, it’s better to borrow money for a mortgage so that you pay less interest over time. Conversely, if you are a lender (a bank or other financial institution), you will want to lend money at higher rates in order to earn more money over time, because the borrower will pay you more interests. If you think about these fundamentals, you can see why the average person might be concerned about rising interest rates.

The Federal Reserve determines the level of the federal funds rate, currently at 0.5%, which serves as the benchmark for rates at all levels. The rate was just raised from 0.25% to 0.5% on March 17. Rates have actually been at historically low levels for a very long time – in 2007 and 2008 they were reduced to very low amounts to help combat the financial crisis. .

Overall, low rates are designed to stimulate the economy. When rates are low, institutions and individuals can borrow at lower levels. Money is “cheap” and low rates are designed to induce investors to borrow and in turn invest that money in things like research, development, job creation, infrastructure and technology upgrades. At the same time, people are encouraged to borrow at low rates to buy homes, start small businesses and spend.

Rates have fluctuated since the financial crisis, but overall they have remained very low. We started to see them increase in late 2019 and early 2020, when the economy was showing signs of strength, but when the pandemic surfaced, the Fed, once again, had to step in to help itself. ensure that the economy does not collapse. As a result, they cut rates to almost zero and have kept them at those levels ever since.

Over the past year, we’ve started to see real signs of inflation, which happens when prices rise and everyday items like food and gas become more expensive. While inflation isn’t always a bad thing — it often signals that the economy is warming and growing — it still isn’t. feel good. Therefore, politicians and economists are hard at work making sure we combat its effects.

Before moving on to your stock portfolio, I want to dig a little deeper into liquidity and inflation. Think about the idea of ​​”liquidity” for a second. The measure of liquidity is based on how quickly you can sell something and turn it into cash. When there is plenty of liquidity in the system, liquidity is readily available. Due to low rates and a number of government programs that have handed out money recently, many Americans have been able to save – Americans’ savings rates have increased dramatically during the pandemic, although they are starting to return to more “normal” levels now that people are going back to work and government subsidies are coming down.

Due to this increase in the money supply, the demand for goods and services has increased, which has, in turn, pushed up the prices of those goods and services. If you add the complete supply chain disruption there is a very compelling story as to why demand has increased and why a decrease in supply due to supply chain issues has led to an increase overall prices.

Now that we’ve cleared up the whole bad thing about inflation, we can focus on its impact on your stock portfolio. Over the past decade, we have seen an explosion in stock prices. Many investors expect double-digit annual returns from their stock portfolios, but I’ll tell you that’s not normal.

The explosion in stock prices can be explained by the increase in the money supply and the fact that stocks have been much more attractive investments than bonds.

Why is that? The appeal of bonds is that they pay you a return or income. A bond is essentially a loan, and when you own a bond, you are essentially lending money to that entity—whether it’s a government, a corporation, or a municipality. This counterparty pays you interest and after a certain period of time, it reimburses your initial investment.

That said, in an environment where interest rates are close to zero, it has been extremely difficult to make money buying bonds. As a result, investors were forced to look elsewhere for returns or interest and turned their attention to the stock market. If you layer that on top of a tech boom and easier access to investing in stocks through technology like online trading platforms and apps, you can see why the stock market has been such an attractive place. to earn money. Apps like Robin Hood and Webbull allowed an easy entry into the stock market, while brokers like Schwab and TD Ameritrade now offer commission-free trading, making the cost of buying and selling stocks zero.

Things are changing, however – with inflation and worries about an overheating economy, the Fed is forced to raise rates, which means mortgages will be more expensive. As a result, it will be more expensive for businesses to borrow, which will hurt household and business balance sheets. All of this is designed to slow down the economy by creating a decrease in demand, an increase in supply and therefore a return to more normal prices (think of lower prices for goods and services like gas, food and clothes).

The shareholding is the shareholding. When you own a share of a business, you are a partial owner. The price of a company’s share is a reflection of the general health of that company. If it suddenly becomes more expensive to borrow and the demand for goods and services decreases, you might see a drop in income. Also, taking into account inflation, you are probably paying your employees more and your costs are higher. As a result, your expenses will increase, which will impact profit margins, and as a result, the stock price could drop in value.

Also keep in mind that much of the explosive growth of recent years has been in “growth stocks,” which are rising in value because investors believe there is potential for explosive growth.

Generally, we don’t own growth stocks because these companies are making a lot of money. For example, consider the case of an investment in a technology company like Tesla. For many years, Tesla didn’t earn a penny, but its stock price jumped at a staggering rate. Investors bought into it because they believed it had the potential to be a huge financial success in the future.

However, this mentality will change in an overheated economy. In this case, investors will instead find it easier to earn interest on investments like bonds or more traditional value stocks (think blue chips) that offer low-risk income opportunities. Over time, if rates continue to rise, you’ll likely see portfolios revert to a more “normal” balance of stocks and bonds.

That doesn’t mean your portfolio won’t continue to grow. This inflationary environment is cyclical. This is not permanent and, overall, general inflation will continue to push asset prices higher. However, in the current environment, it makes sense to look at your portfolio and see if it’s possible to balance it out a bit. Be careful not to be overloaded with high-risk tech stocks – keep an eye out for other opportunities such as value stocks and asset classes such as financials, industrials, consumer cyclicals and energy.

If you don’t want to be so involved in your investment portfolio, consider a robo-advisor, like wealth front and Improvement, which will create a diversified portfolio for you based on your risk tolerance and time horizon. Plus, he’ll rebalance your investments from time to time, including during periods of market volatility, to ensure you’re on track to achieve your goals.

Inflation is something that many generations have never experienced. The last time we had real inflation was in the 1980s, so this is a whole new concept for many investors. I suggest you try to develop a deeper understanding of how inflation and interest rates work and how they impact your overall wealth.

Kristin O’Keeffe Merrick is a financial advisor and financial expert at her family business, O’Keeffe Financial Partners, located in Fairfield, NJ.

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Editorial note: Any opinions, analyses, criticisms or recommendations expressed in this article are those of Select’s editorial staff alone and have not been reviewed, endorsed or otherwise endorsed by any third party.

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