Interest refers to the cost of borrowing or the return on savings. Sounds simple, right? But this rudimentary concept can have extraordinary impacts on our economy.
Interest rates are impacted by inflation and the Federal Reserve’s subsequent monetary policy. I like to use the analogy of bathwater. You want to have the temperature just right. When inflation is high, the central bank turns on the cool water to increase interest rates, making money more expensive to borrow, which can reduce consumer spending and “cool” the economic waters. On the other hand, when inflation is low, the central bank turns on the hot water by decreasing interest rates to accelerate borrowing and consumer spending. As a result, the economic waters heat up.
When interest rates are high, investors want greater returns from their investments to compensate for the loss of purchasing power caused by inflation. When inflation is low, investors may accept lower returns, meaning lower interest rates.
How interest rates and inflation affect the markets
We also see impacts in the stock market. When interest rates are high, some investors depart their stock component in their investment strategies to seek fixed rates on savings vehicles like CDs, fixed annuities or bonds. When enough investors do this, we see a decline in the stock market. When interest rates decline, investors start searching for ways to grow their money, and some may revisit their stock strategy.
Many of my client conversations revolve around this topic. Last year, one of my clients was considering exiting the diversified mutual fund strategy we established to transition to a more conservative strategy. We revisited their “why.” Why are they adding to their mutual fund portfolios? Their answer is they want to make sure they have enough assets to supplement their retirement in eight years.
Their time horizon, or how much time they have to save for their retirement goal, is a valuable piece of information because it helps determine their investment allocation, or how their accounts are invested. After our review, we found it is appropriate for their goal and ultimately decided against the more conservative strategy.
Focusing on the 'why' rather than on emotions
A lot of my clients ask me how to navigate the uncertainty of the interest rate landscape, since we don’t know how the Fed will adjust rates. I ask them to look at their “why” when it comes to their ongoing contributions to retirement accounts, or how they are going to use an investment account. We revisit our goals and time horizons and ask ourselves whether our plan needs a change vs our emotions telling us it needs a change. When we experience negative returns, our emotions tell us to minimize our losses and get out. When the market is doing well, we want to get in and not miss out.
If your investment strategy is to liquidate when the market is down and return when the market is high, that is a recipe for failure. A disciplined investor will revisit their “why” and the path they are traveling to reach that financial goal. That evaluation usually uncovers the opportunity to add more to their investment account when the market is down.
High interest and inflation rates are nothing new — this has happened in the past, and investors got through it. We will, too.
Case studies may not be representative of the results of all clients and are not indicative of future performance or success.
The opinions expressed are those of the author and do not necessarily represent those of the employing firm. Case studies may not be representative of the results of all clients and are not indicative of future performance or success. FM-6001461.1-1023-1125
Isaac Morris is a registered LPL Financial Advisor with TruStage Wealth Management Solutions. Isaac works at Summit Financial Advisors located at Summit Credit Union where he helps individuals and families pursue their financial goals by providing financial advice based on 10-plus years of experience in the industry. He is deeply committed to his clients’ financial well-being and strives to listen intently to their needs and concerns to provide them with just the right help for their unique circumstance.
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