If you own a bond fund, dividend paying stock or ETF — and that seems to be everybody these days, especially those of us who are yield-hungry and aging — just remember: When rates go up, prices go down.
It's the see-saw effect that is second-nature to sophisticated investors, but often overlooked and likely not understood by everybody else.
Here are three things to consider — and it doesn't matter if these are in your IRA, 401(k) or elsewhere:
First, bond mutual funds aren't the same as owning a bond. There is no end date; they don't mature. That means if rates rise, the price of the fund (your underlying investment) will fall. Depending on when you bought the fund, you could lose money. This excellent piece by Morningstar details a stress test than can indicate how much you might lose.
Second, according to Morningstar, an astounding amount of cash has been flowing into emerging-market and junk-bond funds over the past year. Here's the tricky part: The emerging market funds are likely to be less affected by the impact of rising rates in the U.S., but as Morningstar's Christine Benz points out, they tend to be more vulnerable to the overall stock market. In 2008, for example, they got slaughtered. (Read More: How the Fed Is Pushing Investors into Junk Bonds.)
Finally, if you've been buying stocks, stock funds and stock ETFs for the yield, just remember: If rates rise, the yield will rise, but the price of the stock, fund or ETF will likely fall. (Read More: What's Hot in ETFs for 2013?)
"Dividend-paying stocks aren't looking quite as cheap as they were a couple of years ago," Benz wrote the other day. "Back in 2010, the typical dividend-paying exchange-traded fund in Morningstar's coverage universe was notably undervalued relative to our analysts' estimate of fair value of its underlying securities, according to our ETF Valuation Quickrank tool. But following a relatively strong run in dividend payers, most dividend-focused ETFs look pretty fairly valued now..."
In the end, it's all about how much risk you are willing to stomach. I'm convinced most average investors don't even think about it until it's too late.
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