What Does Higher Interest Rates Mean For My Portfolio
This month's blog post is the transcript from a video we recorded and sent to client's on September 22. You can watch that video by clicking here.
The federal reserve raised interest rates again this month another three quarter percent. That puts the federal funds rate at the highest point it’s been since 2008 when they slashed them to zero.
What does this mean for the economy, the market, and your portfolio?
Look, the big hairy problem we’re facing is inflation. If you remember back in the 70’s, the last time inflation persisted, it wasn’t solved until the new federal reserve chairman, Paul Volcker, finally cracked the whip and decided he was going to raise interest rates as high and as long as he needed to solve inflation. We’re kind of in the same situation. As bad as it hurts, rates need to rise to fix the inflation issue we have. And it’s true, rising rates will most likely land us in a recession, most economists believe at some point in 2023.
So what does this mean for your portfolio?
There will absolutely be some short-term pain and we’ve felt that, but let’s break this down and talk about how it affects your bonds and how it affects your stocks. We’ll start with bonds.
Your bond returns are made up of two components: the appreciation or depreciation of the price of the bond and the interest rate you receive.
When interest rates rise, prices of bonds we currently own drop. Think of it this way: If we bought a bond for $100 and it’s paying us 2% interest. And then interest rates rise and new bonds are paying 4% interest, we couldn’t sell our bond for $100, it’s now worth less, simply because it pays 2% interest instead of 4%. If we wanted to sell that bond we would have to discount it to say $90 to make it enticing for someone to buy. This is what is happening with bonds right now. You’re seeing prices of the bonds in your account drop because rates are higher. Now, the good news. This is short term pain. Bonds mature over time and as your bonds mature and the fund buys new ones your interest rates will be higher. Bonds have been a sticking point in the past because the interest rates were so low, well now we can buy 3 year bonds and get 6%-7% interest. So take some solace in knowing bonds are finally a worthwhile investment again going forward.
We’re making a change to how we do bonds going forward. Instead of owning bond funds, we’re going to buy individual bonds. Why would we do that? We don’t ever want to get into a situation where you need money from your account and we have to sell a bond fund when it has gone down in price because rates have gone up. If we buy individual bonds instead of funds that own bonds, we can ladder the bonds so a portion of them mature each year, that means we get our cash back that you can use if you need. For example, if you need $100,000 from your portfolio for spending we can buy $100,000 of bonds that mature in 1 year, $100,000 that mature in 2 years, $100,000 that mature in 3 years and so on and so forth. You collect your 4%-7% interest along the way and each year you get 100% of your principal back. I think this will be a massive improvement going forward.
Now on to stocks…
Rising interest rates are obviously not good for stocks. They hurt companies earnings and earnings are what drive stock prices.
Uncertainty is also totally detrimental to the stock market and there is a lot of that going on right now.
I’m a broken record, but I’ll stick to my philosophy on stocks… they’re intended to only be invested in for money that you won’t need in 10 years or longer. A diversified portfolio has a 100% track record over a 10+ year time horizon and so I truly don’t worry about what happens with stocks in the short term.
Having said that, I think we’re still in for some pain in the next year or so. The market typically bottoms out about 3-6 months before a recession starts. Put another way, the stock market is a leading indicator and a drop like this indicates a recession is coming. The stock market typically starts its recovery sooner than the economy does.
It’s going to take high interest rates to bring inflation down and those high interest rates will most likely propel us into a recession, but once inflation comes down I expect a big rally in the stock market. It hurts your head to think about it a bit… in order to get a comeback in the stock market, we need inflation to come down and in order for inflation to come down the fed may need to force a recession.
Bottom line, I’m not worried. I’m not saying the market is going to recover by the end of the year, I’m not saying things are going to resolve themselves shortly, but I am completely confident that there is a time for all seasons. Things aren’t always going to be great, but patience during times like now is what defines the best investors. Times like now, I’m constantly thinking about each one of you, and what I can do to help. I want to step up my communication in times like now and want each one of you to feel comfortable calling me with question, thoughts, concerns, whatever it may be.
We’re currently doing our semi-annual reviews and if you haven’t scheduled one there is still time to do so. Thank you everyone and we’ll be in touch.