written by John J. Quinnan II
Before you can answer this question, you need to be somewhat familiar with why the Federal Reserve raises rates in the first place. In a nutshell, the Fed increases rates in hopes of curbing economic growth just enough to combat inflation – but not enough to derail an economic expansion. Clearly, the Fed faces a difficult "balancing" act. But even when it makes relatively modest adjustments – such as the series of one-quarter point hikes that characterized the 2004-2006 rate escalation – its actions will have an immediate impact on the financial markets.
Stock prices sometimes drop after the announcement of another "bump" in interest rates. Higher rates make it more expensive for companies to borrow to finance their operations – and if a business is struggling to grow, its problems will be reflected in its stock price. Bond prices also tend to fall when interest rates rise. Why? Because if a new, short-term bond pays, say, 4 percent interest, no investor will pay you full price for your existing bond that only pays 3 percent; to sell it, you’ll have to offer it at a "discount." You can’t control what happens to interest rates, but you can manage your response to rate increases. Consider these suggestions:
• Diversify. Build and maintain a diversified portfolio of stocks, bonds, government securities, certificates of deposit and other securities. Not all investments are affected in precisely the same way by interest rate increases. For example, some stocks, such as those issued by financial services companies, may actually benefit from a rise in interest rates. By diversifying your holdings, you can help protect yourself against the sharp price declines that may hit some assets when interest rates increase.
• Look for quality. Keep investing in high-quality stocks. Over the long term, high-quality companies – those with solid management, competitive products and strong track records of profitability and earnings – are likely to reward you, no matter where interest rates are headed. Also, stick with "investment-grade" bonds, which carry the lowest risk of default.
• "Buy and hold." If you’ve chosen high-quality stocks, you don’t need to unload them solely because interest rates may be rising. You’re much better off holding these stocks for the long term – until either your needs change or the companies themselves move in a different direction. And if you hold your investment-grade bonds until maturity, you will almost certainly receive all your principal back, no matter how many times interest rates have risen or fallen. • Build a bond ladder. If you invest in bonds, you don’t want to constantly adjust your holdings in response to changes in interest rates. Instead, build a "bond ladder" – a group of bonds of varying maturities. When rates are rising, you’ll be able to reinvest the proceeds of short-term bonds that come due, and when rates are falling, you’ll have your long-term bonds, with higher rates, working for you.
By following these suggestions, you can go a long way toward achieving investment success – in all interest-rate environments.
Submitted by Edward Jones Representative John J. Quinnan II, Investment Representative, 12900 Old US 27, Suite 4, Dewitt, MI 48820. He may be reached at 517-668-2406 or toll free at 877-668-2406.