What to do when interest rates rise?


Dear SmallIvy,

If an investor expects higher interest rates, what should that investor do?

Thanks,

Pete

Dear Pete,

The effect of rising interest rates is generally to cause bond prices to fall, thus causing their yields to increase.  This is because the interest rates in bank accounts will rise, causing investors to require more interest before they will buy bonds which are more risky.  (If you can put money in a bank account and get 5% interest, why would you buy a bond which carries the risk of default if you only received 5%?)

As bond prices fall, the price of stocks will also fall.  Here again, in order to justify the greater risk an individual is taking on when buying stocks, the price must be low enough compared to expected earnings and interest rates to allow the total return to justify the added risk. 

Higher interest rates are also indicative that inflation may be on the way.  This would cause the Federal reserve to raise borrowing costs, thereby causing the economy to contract.  This will also cause the bond and stock markets to decline.

The best place to be when interest rates are rising is in cash (a money market fund).  There is really no safe place to be invested.  Second best places may be a foreign stock fund (although with economies so interconnected, this may not offer protection) or maybe in stocks but writing covered calls to generate income.  This second strategy, however, requires experience and the losses from declining prices will probably outweigh the premiums collected from selling the calls.

As stock prices fall, the investor can start buying some shares.  Expect, however, to not hit the bottom, so buying in several intervals is a good strategy to improve the cost basis.

To ask a question, email  vtsioriginal@yahoo.com or leave the question in a comment for this blog.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. In addition the writer of this blog is not an accountant and writings should not be taken as tax advice which should be left to a CPA.  Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing

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