Whether they’re going up or down, interest rates can have a big effect on your investments, and therefore have the potential to pose a risk (or a benefit) to your financial wellbeing.
When interest rates go up (as they’ve been doing), bond investments tend to go down, which could decrease the value of any older bonds you possess. For example,
if you have a bond that pays 3 percent and rates rise to 5 percent on the open market, no one will buy your bond unless you discount its value to make it equal to the 5 percent offered elsewhere. You would lose money.
Rising interest rates can also present a risk to the stock market. When rates rise, businesses that borrow money have to do so at higher rates, as do consumers who buy cars and houses, etc. Since this creates higher total costs for some goods, businesses and people tend to borrow less and buy less, and this can slow down the economy—usually not a good thing for the stock market.
Declining interest rates pose a different risk. If bonds and CDs mature at a time when rates are down, you could suddenly go from a great rate that had been providing you with a nice income to interest that’s not even one percent.
How can you mitigate interest rate risk? One way is you could “ladder” any investments with maturity dates. In other words, if you invested in CDs, you would buy one that matured in 1 year, one that matured in 3 years, one that matured in 5 years, etc. Since your money wouldn’t be locked away in one CD, you could take advantage of rising interest rates. You could also shorten the duration of your bonds (the length of time until the bond matures). Generally speaking, the shorter duration of your bonds, the better they’ll perform in a rising interest rate environment. The reverse is also true: If interest rates are going down, long-term bonds will be more valuable because the higher interest rate was locked in for a longer period of time.
As you can see, you could heighten your risk by not considering interest rates when you build your portfolio. You can probably also see that properly constructing such a portfolio is complicated. We’d love to help you.