After two years of record-low interest rates, as of 2022 interest rates are now skyrocketing, and this can have a destabilizing effect on the stock market - and your investments.
But how can higher interest rates affect your investment portfolio? And what investments should you pursue or avoid to reduce the effects? Let’s take a look.
What Are Interest Rates?
But let’s get the basics out of the way first. What are interest rates, and what do people mean when they say the doom and gloom phrase - “interest rates are rising”?
Interest rates refer to the federal fund rates, and how those rates affect borrowing and credit rates. The federal reserve determines the federal fund rates, which becomes the target rate that banks will use to borrow from the federal reserve, in order to lend money to other banks and to consumers. These “consumers” include everyone from corporations to the everyday person who borrows money or has credit.
If the federal reserve chooses to change the cost of borrowing money, this will affect the demand for goods and services, eg. lower interest rates mean more credit cards which in turn boost sales. Lower interest rates spur the growth of the economy.
Overall, the federal fund rate is one of the most important things that affect the US economy. It affects inflation, employment, the stock market, and much more.
Low-interest rates are attractive for two reasons:
It boosts economic growth so companies can profit
Investing in the stock market becomes more attractive than keeping money in the bank.
High-interest rates often have the opposite effect, because:
They lead to less spending and less profit for the companies. This can slow the economy and in some cases even cause it to regress.
Many companies rely on low-interest rates for funding. High-interest rates mean their repayments are much higher, which can end up killing the company.
Fewer people are willing to borrow money to invest in the stock market. But this doesn’t mean that all stocks and all corporations will be affected in the same way.
How You Should Invest
So how should you invest in the stock market when interest rates are up? Well, when you are putting together an investment plan in the face of rising interest rates, these are the things you should keep in mind.
1. Financials Matter
When you invest in individual stocks, the financials of the company matter… a lot. Especially when interest rates are high, and especially if they are heavily in debt.
When the economy is booming and interest rates are low, a company can be doing well even if its financials aren’t looking good. But when interest rates rise, that puts those companies in jeopardy. Whereas if a company has limited debt and a lot of cash, it will undoubtedly fare better.
Of course, financials and debt aren’t the only matter that will affect the success of a company, but they are very important to keep in mind.
2. High-Risk Assets
A lot of people will invest in high-risk assets, particularly cryptocurrency, as a hedge against inflation, and they will even borrow money to invest in cryptocurrency when rates are low. But when rates begin to rise, you are going to see a drop in these investments.
When the economy is going strong and people have money to spare, they are more inclined to invest in riskier assets. Of course, when interest rates are high, the opposite happens. In times like this, people tend to invest more conservatively.
If you are the type of person who likes to invest in high-risk assets, now might be the time to reassess your portfolios in this respect.
Bonds are debt securities issued by corporations, governments, municipalities, etc. They are low-risk and low-reward compared to stocks.
When interest rates change, so does the demand for bonds. In general, you should avoid fixed-rate long-term bonds when interest rates are rising. This is because you are locked into whatever term the bond is, so the more long-term the bond, the more risk you are taking on. If interest rates go up after you have purchased the bond, you are stuck having to sell it off at a lower price.
The federal reserve has confirmed that interest rates are on the up, so why risk taking on a fixed-rate bond? Unlike the uncertainty of the stock market, you know how bonds will fare based on what the federal reserve reports.
If you still want to invest in bonds, go for bonds that are not fixed-rate, where the rate can be adjusted depending on interest rates. A bond ladder is another way to avoid the pitfalls of high-interest rates, which involves investing in short-term bonds in increments of 6, 9, 12, and 24 months. Every time a bond matures that money is moved onto a new bond at a higher rate.
4. Index Funds
What if you choose to invest in a company with great financials and you still get it wrong? After all, there are many factors that dictate whether a company does well as the economy slows. Investing in individual stocks can be tricky.
However, stock market index funds are a great opportunity for diversification, which is a great hedge against risk in uncertain times. While one company in an index fund may not do so well, others will thrive.
Investing in a total stock market index fund may not be as glamorous as investing in individual stocks, but it will help to mitigate the anxiety around rising interest rates and their effect on your portfolio. Historically, the stock market has only continued to go up, so even if some stocks drop, you are almost definitely going to come out better off even when interest rates have plummeted.
Hearing talk about rising interest rates and possible recession can be scary. But the best thing you can do is research, stay informed, and find the most effective ways to reduce risk. The advice above is some of the most important ways to ensure that your investments survive during uncertain times.