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Welcome to Select's newest advice column, Getting Your Money Right. Once a month, financial advisor Kristin O'Keeffe Merrick will be answering your pressing money questions. (You can read her first installment here on what to do with your excess cash.) Have a question you want to ask? Send us a note at AskSelect@nbcuni.com.
I am a little rusty on my economics. I would love a refresher on why a rise in interest rates could potentially impact my stock portfolio. Can you explain?
Rusty in Ridgewood
This is a great question and an important one. First, let's talk about "interest rates" in the general sense. Why are they important at all?
Interest rates determine the level at which we can borrow or lend money. Think about it in terms of mortgage rates: while rates are low, it's better to borrow money for a mortgage so that over time you'll pay less in interest. Conversely, if you are a lender (a bank or another financial institution), you'll want to loan money out at higher rates so you can make more money over time as the borrower pays you more in interest. If you think about these fundamentals, you can understand why the average person might be concerned about a hike in interest rates.
The Federal Reserve determines the level of the Federal Fund Rates, currently at 0.5%, which serve as a benchmark for rates across the board. The rate was just raised from .25% to .5% on March 17. Rates have actually been at historically low levels for a very long time — back in 2007 and 2008, they were cut to very low amounts to help combat the financial crisis.
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Overall, low rates are designed to stimulate the economy. When rates are at low levels, institutions and people can borrow at lower levels. Money is 'cheap' and low rates are designed to incentivize investors to borrow and, in turn, invest that money into things like research, development, job creation, infrastructure spending and technology upgrades. At the same time, people are enticed to borrow at low rates to buy homes, build small businesses and spend.
Rates have ebbed and flowed since the financial crisis but overall, they've stayed very low. We started to see them move higher in late 2019 and early 2020 when the economy was showing signs of strength, however when the pandemic surfaced, the Fed, once again, had to spring into action to ensure that the economy didn't collapse. As a result, they cut rates to almost zero and have kept them at those levels since.
In the past year, we've started to see real signs of inflation, which occurs when prices increase and everyday items like food and gas become more expensive. While inflation isn't always a bad thing — it often signals that the economy is heating up and growing — it still doesn't feel good. Therefore, politicians and economists are hard at work to ensure that we combat its effects.
Before we move onto your stock portfolio, I want to dive a bit deeper into liquidity and inflation. Think about the idea of "liquidity" for a second. The measure of liquidity is based on how quickly you can sell something and turn it into cash. When there's a lot of liquidity in the system, cash is readily available. Due to low rates and a number of government programs that have been giving out money recently, many Americans have been able to save up — Americans' savings rates increased dramatically during the pandemic although they are starting to return to more "normal" levels now that people are returning to work and government subsidies are receding.
Because of this increase in money supply, demand for goods and services has increased, which has, in turn, pushed up the prices of these goods and services. If you add in the complete disruption of the supply chain, there's a very compelling story as to why demand has increased and why a decrease of supply due to supply chain issues has led to the increase of prices overall.
Now that we have cleared up this whole pesky inflation thing, we can focus on how it will impact your stock portfolio. Over the past decade, we've seen an explosion of stock prices. Many investors have come to expect double-digit annual returns from their stock portfolios, but I will tell you that this is not normal.
The explosion of stock prices can be explained by the increase of money supply and by the fact that stocks have been far more compelling investments than bonds.
Why is that? The allure of bonds is that they pay you yield, or income. A bond is essentially a loan and when you are the owner of a bond, you are essentially lending that entity — whether it's a government, corporation or municipality — money. That counterparty pays you interest and after a certain period of time, they pay you back your initial investment.
That said, in an environment when interest rates are close to zero, it's been extremely difficult to make money by buying bonds. As a result, investors have been forced to look elsewhere for yield, or interest, and have turned their attention to the stock market. If you overlay that with a technology boom and easier access to investing in stocks through technologies like online trading platforms and apps, you can understand why the stock market has been such a compelling place to make money. Apps like Robinhood and Webull have allowed for easy entry into the stock market, while brokers like Schwab and TD Ameritrade now offer commission-free trading, making the cost to buy and sell stocks zero.
Things are changing, however — with inflation and worries about an overheating economy, the fed is forced to hike rates, meaning mortgages will be more expensive. As a result, it'll be more expensive for corporations to borrow, which will hurt both household and corporate balance sheets. This is all designed to slow the economy down by creating a decrease in demand, an increase in supply and therefore the return to more normal pricing (think lower prices in goods and services like gas, food and clothing).
Stock ownership is equity ownership. When you own a share of a company, you're a partial owner. The price of a share of a company is a reflection of the general health of that company. If it's suddenly more expensive to borrow and demand for goods and services decreases, you could see a dip in revenue. In addition, given inflation, you're likely paying your employees more and your costs are higher. Therefore, your expenses will go up, which impacts profit margins and as a result, the stock price could go down in value.
Also keep in mind that so much of the explosive growth over the past few years has been focused on "growth stocks,'' which go up in value because investors believe there is a potential for explosive growth.
Generally speaking, we do not own growth stocks because these companies make lots of money. For instance, think about the case of investing in a technology company like Tesla. For many years, Tesla did not make a single dime, yet its stock price surged at a startling rate. Investors were buying into it because they believed it had the potential to be a huge financial success in the future.
That mentality will change, however, in an economy that's overheating. In that case, investors will instead find it easier to earn interest on investments like bonds or on more traditional "value" stocks (think blue chips) that provide lower risk income opportunities. Over time, if rates continue to creep higher, you'll likely see portfolios shift back to a more "normal" balance of stocks and bonds.
This is not to say that your portfolio will not continue to grow. This inflationary environment is cyclical. It's not permanent and overall, general inflation will continue to push asset prices higher. However, in this current environment, it makes sense to look at your portfolio and see if there is room for you to balance it out a bit. Be careful to not be so overloaded with high risk tech stocks — keep your eye on other opportunities like value stocks and asset classes like financials, industrials, consumer cyclicals and energy.
If you don't want to be as hands on with your investment portfolio, consider a robo-advisor, like Wealthfront and Betterment, which will create a diversified portfolio for you based on your risk tolerance and time horizon. Plus it will rebalance your investments from time-to-time, including during periods of market volatility, to ensure you're on track to reach your goals.
Inflation is something that many generations have never experienced. The last time we had real inflation was in the 1980s so this is a brand new concept to many investors. I suggest you try to develop a deeper understanding of how inflation and rates work and how it can impact your overall wealth.
Kristin O'Keeffe Merrick is a Financial Advisor and money expert at her family-run firm, O'Keeffe Financial Partners, located in Fairfield, NJ.