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.
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.
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.
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.
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:
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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