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Interest rates are still rising, which has led to speculation about what this means for the stock market. Some investors believe that while higher interest rates will cause the stock market to fall in the short term, they will eventually lead to an economic boom. Others worry that raising interest rates will send the economy into a slump and possibly lead to a stock market crash.
Changes in interest rates typically have an immediate effect on the stock market but may take up to a year to significantly impact the rest of the economy. Investors can make better financial decisions if they know the connection between interest rates and stock markets and how changes may impact their investments.
The Federal Fund Rate
The interest rate that impacts the stock market is the federal funds rate. The Federal Reserve affects the federal funds rate to keep inflation under control. The Federal Reserve is effectively reducing the amount of money available for making purchases by raising the federal funds rate. As a result, getting money becomes more expensive. On the other hand, when the Federal Reserve lowers the federal funds rate, the money supply rises.
The prime interest rate, which commercial banks charge their most creditworthy clients, is heavily based on the federal funds rate, making the federal funds rate significant.
Interest Rates and Correlation to the Stock Market
In most cases, higher interest rates imply a declining stock market. This is because as interest rates rise, companies will borrow less money. As a result, their earnings will grow at a slower rate than expected by investors.
Investing in technology stocks is riskier than investing in bonds. This has an impact on all sectors of the stock market. For example, an investor may put money into a technology stock with the expectation that it will grow 10% yearly. When interest rates rise, growth projections fall to 5% per year. As a result, this investor may believe that the risk associated with a potential 5% return is too great, and they choose to invest in bonds instead.
If many investors do this, the demand for stocks will fall. When the market falls, stock prices must also fall so investors can find a more appealing price.
The most important thing for investors to remember is that not all stocks will fall simply because interest rates are rising. Some stocks perform well when interest rates are rising. Furthermore, stocks with strong balance sheets and a well-defined revenue stream may only experience minor effects.
When Interest Rates are Rising, What Investment is the Best?
There is no such thing as a one-size-fits-all approach to investing. What works for one person may not work for the next. The most important thing is to have a strategy you are confident in.
High-interest rate periods are unavoidable in your investing career. The key is to create a portfolio that allows you to handle the volatility with higher interest rates.
Here are a few things to consider as you build your portfolio. Most importantly, it is advisable to spread your holdings across multiple asset classes. This ensures that you have other investments to fall back on if one sector struggles. Also, prioritize quality over quantity. It is preferable to have a few high-quality stocks rather than many low-quality ones. To ace this, you must understand your investment objectives. Knowing why you are investing will help you get through a down market. This is frequently measured in terms of time (short-term, long-term, etc.). However, you can’t be fluid and adaptable if you don’t keep some cash on hand.
The Bottom Line
Although there is a reasonably indirect relationship between interest rates and the stock market, the two typically move in opposite directions. You should be able to weather any storm if you have an investment plan that identifies your investment goals, time horizon, and risk tolerance. Selling out of your holdings out of fear is the last thing you want to do as an investor.