Why You Shouldn't Worry About Higher Interest Rates

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For years, U.S. investors have had a major ally in the Federal Reserve. Benchmark interest rates have been at zero. The Fed pumped billions of dollars into the economy each month. An historic bull market ran wild.

And that's all likely to change in six weeks.

Fed Chair Janet Yellen made news recently when she gestured toward an interest rate hike in six weeks. Observers have long argued a fall hike was in the cards. Yet Yellen's comments make it seem all but inevitable. Federal Reserve officials seem confident the U.S. economy is strong enough to absorb a hike.

Which raises the million dollar question for investors. How the stock market will react? 

To answer that question, we need to peek back into history.

U.S. interest rates have been volatile over the last four decades. When looking at the historical data we see patterns develop. According to a study by Russell Research, equities have done better during periods of falling interest rates over the last 40 years. Yet the difference is only about one-percent. Overall, equities tend to do best when interest rates fall quickly, or rise slowly. 

It's also interesting to note that foreign stocks outperform U.S. stocks during rising periods. Commodities, private equity and REITs also perform better when rates rise. Treasury bonds do not, though that's no great surprise. The private real estate market also tends to suffer.

Historical information offers useful context. Yet we should note this data depends on a huge variety of factors. Stock market bubbles and other events can skew the numbers, for example.

How dramatic will the impact be?

It's natural to worry about higher rates. The climate for investors over the last few years has been optimal. Yet the serious concern displayed in some corners is not warranted. 

The hike is likely to be gentle. Borrowing costs are unlikely to surge. Investors seem to have internalized this idea. Markets across the globe rose upon news of Yellen's statement. China, the one outlying exception, is dealing with its own serious market crisis.

It's also important to note rate hikes aren't linked to bear markets. Historically, volatility jumps in the three months after a rate hike. Markets tend to have a negative reaction -- at least initially. Yet these effects usually disappear within six months or a year.

It's also key to note just how low rates are. Even after a hike, interest rates will still be low by historical standards.

Plan for action

Are you worried about the effect of rising rates on your portfolio? Then take a deep breath. History shows us any negative effect is likely to be fairly fleeting. It's important to act prudently. 

The most serious risk to any investor usually comes from his own irrational reaction, rather than external events. With that in mind, here are a few things to consider.

  • Remember that rate hikes affect everyone differently. Those with money in CDs or money markets will benefit, for example.
  • Rate hikes are a long-term positive for stocks. Yet some do better than others. Growth stocks with no dividends bear particular notice.
  • Large banks and financial services firms will likely see a short-term boost. This natural bounce can work to an investor's benefit.
  • Pay attention to the duration of bonds. High quality bonds with shorter maturity may be a better bet.
  • Consider tilting toward sectors that are economically sensitive, such as energy and financial. ETFs are a smart way to do this.
  • Remember that higher rates will improve returns over the long run. Studies have shown that the average five year return for global stocks and bonds improves with higher rates.

Rate hikes create uncertainty -- particularly after almost a decade of rock bottom interest rates. Yet the savvy and prepared investor can turn this situation to his benefit by following the advice outlined above.

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