Interest rates go up and interest rates go down—an inevitable part of the economy and financial landscape. What does it mean for your investments? Different types of investments respond to changes in interest rates in different ways. Specifically, there are significant differences in how equity and fixed-income investments (like bonds) respond to fluctuations in interest rates.
Equities refer primarily to stock investments, as well as some mutual funds and Exchange Traded Funds (ETFs). Changes in interest rates certainly impact equity stock prices; but a number of other factors, including the stock’s industry, determine exactly how and how much. Stocks in a luxury high-end goods company, for example, may be negatively impacted by high interest rates because consumers will have to pay more on the money they borrow to purchase them. On the other hand, stocks in companies that produce consumer staples are often less affected by rate fluctuations.
Fixed-income investments refer to bonds or cash investments, as well as some mutual funds and ETFs. Typically the value of fixed-income investments moves in the opposite direction of interest rates. When interest rates go down, bond prices go up; when interest rates go up, bond prices go down. This means that if you buy bonds when rates are low and then sell them after rates rise but before they mature, you will likely have to sell at a lower price.
Investing in Today’s Environment
With a rise in rates inevitable in today’s low-rate environment, bonds might seem like an unattractive investment option, since their values are likely to decrease along with an increasing interest rate. However bonds can still be a valuable part of an investment portfolio; their price is only one part of the equation that explains their value.
Beyond their price, bonds provide a regular source of income that is a key part of how we calculate their total value as an investment vehicle. Also, bonds have historically been a less volatile and unpredictable investment choice than stocks, allowing them to lend some consistency to a balanced portfolio.
Positioning for Success, Regardless of Rates
So what are the best investment choices for the current economic situation? What happens if (when) rates go up? How can you protect investments from interest rate fluctuations? I have a range of tools and techniques to factor rates and other economic factors into my clients’ portfolios.
For example, in a low-rate environment like the one we’re in now, laddering bonds can help protect against the inevitability of a rate rise. When bonds are laddered, investment dollars are divided among a variety of bonds with different maturity dates. This means that bonds will mature at staggered times, and you’ll be able to reinvest over that course of time. Laddering can allow your bond investments to give you consistent income with lower risk.
The key to a portfolio that can withstand economic factors like interest rate changes is diversification. Because different investments react to rate fluctuations differently, a well-balanced portfolio can provide a buffer to change.
When I create, evaluate and update my clients’ portfolios, I consider the economic environment along with their unique situation, investment timeline and goals to create a strategy that will give them the ability to ride out changes and fluctuations in the marketplace.