Investors should consider higher interest rates very carefully in 2016
On Dec. 4, the U.S. Department of Labor announced that the economy had added some 211,000 jobs in November, more than analysts had predicted. The government also revised previous numbers to show that more jobs were created in September and October than originally estimated.
So it seemed almost inevitable that the Federal Reserve finally would feel confident enough about the economy to begin raising interest rates at its December meeting. By the time you read this you’ll know whether it happened or not; experts have been incorrectly predicting higher rates for years now.
But even if the Fed defied expectations yet again, it’s still a good time to think about what higher interest rates mean for your portfolio.
“It will happen. We just don’t know when,” says Jerry Goss of Goss Wealth Management.
An investor’s mix of stocks and bonds generally varies based on the investor’s age and risk tolerance. Because people are living longer, it might be a good idea for investors to be slightly more weighted toward equities than they might have been in the past, Goss suggests. For example, a 50-year-old investor who might have had a 70/30 mix of equities and bonds 10 years ago might be at 75/25 today.
“Statistically, they may be around for 20 or 30 years [after retirement], so that’s still a long term,” he adds.
That doesn’t necessarily mean bonds should be abandoned, however.
“If you make the assumption that interest rates are going to go up, you’re still going to want to be in bonds, but you’re going to want to be in the right types of bonds,” Goss says.
In a rising interest rate environment, bonds that mature quickly might make more sense. Floating rate funds, in which the interest rate is adjusted every 90 days, are more favorable in a higher interest rate environment than in a lower rate environment, he says.
But even assuming a recent bump, Fed Chairwoman Janet Yellen has made clear that the benchmark rate will be raised gradually. And it’s not as if the economy is soaring or that inflation is rampant. So interest rates likely will be relatively low for the foreseeable future.
“It’s awfully hard to own bonds that are paying really low interest rates right now,” says Jason Windham, president of the Shobe Financial Group.
As Windham points out, bonds aren’t really the growth side of your portfolio. They’re mostly in there because they’re less volatile than stocks.
But bonds are not risk-free. If interest rates go up, bond prices typically go down.
“So you kind of get double-whammied a little bit,” Windham says. “You’re getting low interest rates, and then the potential that if interest rates go up, the bond prices of those can go down.”
Simply holding more cash is another option. He also mentions bonds with a shorter maturity shelf-life, which are less price-volatile in the face of rising rates.
With his clients, Windham says, it often just comes down to risk tolerance. Some people are still nervous about investing in the stock market. At the same time, the low interest rate environment make bonds unappealing to many.
So what often ends up happening is those two factors counterbalance each other, and the proportion of stocks and bonds ends up being pretty much the same as it would have been if a person of the same age with the same goals had been investing 10 years ago, he says.
Certified Financial Planner Chad Olivier echoes the importance of investors being realistic about their risk tolerance and income needs. If you have too much money in stocks when there’s a correction, you could find yourself selling those investments at a depressed price.
Short term individual bonds, CDs and fixed interest rate annuities that take three to seven years to mature can provide a more consistent income. As short term bonds mature and interest rates rise, Olivier says, the investor could look into investments with longer maturities, “laddering the investments” by going to seven, nine, 12 and 15 year maturities, for example.
Of course, every investor is different, and a professional can help you decide what’s best for you. Mark Simmons of Simmons Asset Management takes the unconventional view that you’re probably better off with no bonds at all.
“To me, having bonds in a portfolio doesn’t protect against anything,” he says. “I think having them in a portfolio increases risk.”
At best, he says bonds only spread out risk. Rather than a portfolio with bonds and stocks, he recommends a portfolio with equities and an insurance umbrella.
“If you can protect seven years worth of income, any sort of pullback in the market doesn’t affect your ability to live off your retirement,” Simmons says.
Two years worth can be in cash, CDs or a money market account. The other five can go into some sort of insurance annuity, in which you’re guaranteed a certain return. The upside is capped, because if the investment performs better than what was promised you don’t get the difference, but you’re protected from a downturn.
Simply spreading the risk with, say, a 60/40 equity/bond allocation won’t do you much good if there’s another crash, Simmons says.
“What we’ve learned is that when you go through major market corrections, it doesn’t matter what you’re in, it’s going to fall,” he says. The more important consideration, he says, is making sure you don’t outlive your money.