Why It Pays to Take an Interest in Interest Rates

September 14, 2016
VMD Staff

Interest rates pop up in the news from time to time, but many investors don't know much about them beyond "will they or won't they" Federal Reserve coverage and home mortgage rates. However, investors who take the time to learn about interest rates can gain a significant advantage.

If you follow your investment returns closely, you’ve certainly noticed that interest rates have been very low since the recession of 2008 and 2009. They’ve been kept low in part by the Federal Reserve (which sets short-term interest rates)—to keep the cost of borrowing money as low as possible. Low interest rates can be good and bad for investors—not so great for investment income from bonds and other investments, but attractive for mortgage-seekers, entrepreneurs, and other borrowers. The latter groups tend to stimulate economic growth.

Recovery from the recession has been slow, but the Fed’s decision to keep short-term rates low appears to be paying dividends now. Unemployment is down nationally, home values are on the rise, and other economic indicators are showing the potential for a period of sustained growth.

What does this mean for you as an investor?

Economic growth rarely comes without potential for volatility. If you’re invested heavily in stocks, you may see some greater than usual fluctuation in your portfolio day to day. But it’s important to keep in mind that volatility, in and of itself, is not a bad thing! In periods of growth and volatility, stocks tend to trend higher. This is particularly true for companies whose profits tend to swing up or down based on consumers’ disposable income. Growth stocks tend to do well in a rising-rate environment, while dividend-paying securities—which have been popular in the lower-rate environment—may overcorrect and drop a bit in value.

Bond prices have an inverse relationship with interest rates. As interest rates rise, bond prices generally go down. But keep in mind that this isn’t always the case, and it isn’t always true for all types of bonds. Maintaining diversification through investing in several different types of bonds will serve you well.

Note that small rises in short-term interest rates don’t have a big impact on rates offered by savings accounts or money market accounts. These are not earnings vehicles to begin with, of course, but having short-term saving for purchase you expect to make in the next few years may keep you from taking money out of longer-term investments during volatile times.

The key thing to remember about your savings and investments is that the economy is always cyclical. What is up today may be down tomorrow, and vice versa. Your savings and investments, and in particular your retirement investments, should be designed for long-term growth. If you have at least 10 years before you plan to retire, that is a good window for riding out any short-term market volatility. Overcompensating for a shift in interest rates, or trying to “time the market” by anticipating changes and acting before other investors, is often a recipe for a troubled portfolio.

Remember your strategy, and stick to it (especially if it’s good!)

Hopefully, you put a lot of thought into your saving and investing goals when you first made them. This is especially true for retirement investments, which should always match up with your goals, strategies, and risk tolerance. If interest rates do rise in the short-term, making impulsive financial decisions probably goes against the principles you espoused when setting up your investment and savings plans. Rising interest rates can and should be considered when making future allocation decisions, but they shouldn’t be the primary concern.

What should be your primary concern? Continuing to invest as much as you can, as often as you can, into your workforce retirement plan or individual retirement account. If you continue to do that, you should have nothing to fear as the economic wheel keeps on turning.