Over recent months, the U.S. Federal Reserve has raised interest rates several times. The benchmark Fed funds rate, which many financial institutions use to peg their interest rates, now stands at 2.25%-2.5%, up from historically low levels.
At the same time, the major market averages, such as the Dow Jones Industrial Average, lost value in roughly the period from April of this year to late July. If you’re nearing retirement (or in any other financial circumstance where you watch both markets and interest rates), you may be keenly interested in understanding how rising interest rates can affect your portfolio.
This article explores these topics:
- Why interest rates can affect your investment portfolio
- The importance of diversification among your assets
- What happens economically when interest rates rise
- How federal rate hikes might affect the stock market
- The likely effect of inflation on bonds and other assets
Rising Interest Rates and the Stock Market
Financial modeling shows that retiring just prior to or in the midst of a down market can increase the likelihood of retirement failures. Your starting portfolio may be worth a great deal less than you had planned. You may be able to draw out less money than you were counting on.
L&W wealth advisors in Houston can be helpful when dealing with a financial crisis or market downturn. Our goal is to help you feel more confident that you are doing all possible for protecting your assets. Let’s discuss how your assets are affected by interest rate hikes.
While it’s true that the major interest rate benchmarks have risen in the same period as the markets have seen a downturn, it is not historically true that rising interest rates always lead to a decline in stocks. In fact, the record on linkage between these two things is mixed. The overall state of the economy and the performance of individual companies have much more to do with stock market results than interest rates do.
However, rising interest rates can indeed hit the stock market negatively in the short term. Why? There are several reasons. The Fed uses interest rates as a tool to combat inflation (the primary reason for the current set of hikes). But, rising interest rates also make money more expensive for businesses and consumers. As a result, businesses may stop expanding, and consumers may curtail their buying when rates start climbing upward.
Businesses and consumers pulling in on their spending can affect the overall economy. Growth in the economy may slow down, or even enter a recession. Slowdowns and recessions are not good for stocks because they affect company profits. Inflation isn’t good for a lot of stocks, either. This is because, again, both businesses and consumers tend to rein in their spending when inflation becomes very high, as it has been this year.
So, the correlation between dropping markets and rising interest rates doesn’t result automatically just because rising rates are bad for markets; it occurs because rising rates can both signal and cause economic problems—and those economic problems can impact stocks negatively.
Also, it’s important to remember that higher interest rates are good for several investments. They are a positive benefit to some classes of stock, such as financial institutions (because those companies can charge more for their basic product, which is money). Higher interest rates can positively benefit investors in bonds, for example, particularly in the long-term. They can potentially be a positive benefit to cash, as well, because interest rates on cash instruments, such as certificates of deposit (CDs) and savings accounts, will often move higher.
Diversification Is Key to a Strong Retirement Portfolio
So how do you protect your assets if a down market ensues from a period of rising rates? Diversification and working with your investment manager are key. Diversification is an important component of risk management, so it may make sense to turn to an investment advisory firm to help prudently diversify your portfolio.
Diversification is simply the discipline of dividing your retirement portfolio among multiple asset classes to manage risk. The three most widely-utilized asset classes in retirement portfolios are usually stocks, bonds, and cash. The latter two can potentially provide some stability and moderate return. Bonds tend to fluctuate less than stocks in price, and cash instruments rarely fluctuate at all. Both provide interest. However, interest rates were at historically low levels for roughly the past decade (until the recent round of rate hikes). So, interest was low.
Stocks, by contrast, can provide greater appreciation potential, given appropriate time horizons. Even counting bear markets (declines of 20 percent or more), the popular indices for blue chip major U.S. stocks has returned nearly 10 percent on average over the past century. But there’s also no denying the inherent volatility of stocks; downturns can happen at any time. Stocks are riskier than either bonds or cash.
However, stocks have also been one of the few asset classes that have consistently kept investors ahead of inflation. (Historical patterns obviously cannot guarantee future performance.) Inflation is on our minds this year, because inflation hit 9 percent. The longer-term U.S. average is roughly 2 percent per year. Inflation erodes your money, which is a threat for retirees.
A wealth manager intends to help you balance your portfolio among asset classes to meet your goals and your retirement timing plans, using a prudent mix of bonds, cash, and stocks.
A word about bonds and interest rates: While bond yields may climb with interest rates, bond prices move inversely. When rates rise, bond prices fall. Your investment manager can work with you to manage the maturity structure of your bond holdings so that you can potentially benefit from yield increases while trying to avoid or minimize a drop in prices.
Diversification in Stocks
We also will generally emphasize the importance of diversifying your stock choices. As noted above, some stocks may potentially be positively affected by interest rate increases. (Financial stocks historically have behaved this way in some environments). In addition, dropping markets may cause investors to favor more established companies with dividends. This can potentially show up in more stable stock prices for these stocks as a result. A well-constructed, diversified stock portfolio should be assembled taking these kinds of examples into consideration.
Never Panic Sell
One final word of advice: It’s human nature to be tempted to sell stocks when you see the markets plummet. Don’t. Don’t. Don’t. Historically, U.S. markets have always risen after a decline. If you sell simply because the market is dropping, you’ll likely just lock in a loss that you otherwise were highly likely to make back and then some.
Be sure to look at the total return of your investment and not just short-term performance. Over time, a well-chosen retirement portfolio has a good chance to satisfy your investment goals in the long-run.
Consult a Wealth Advisor in Houston, Texas
Concerned about retirement plan failures or an eroding portfolio? We believe retirement planning with an experienced wealth advisor in Houston, Texas, can help you avoid a retirement plan that failed due to market changes. Make a plan to protect your assets during a market crisis. Contact us today.
