Should You Worry About Rising Interest Rates?
Chapter 28 of The Rational Investor
Welcome to another installment of project “passive wealth,” where I will be releasing my next book on investing (working title: “The Rational Investor”) chapter by chapter to paid subscribers of Making of a Millionaire.
Chapter 28: Should You Worry About Rising Interest Rates?
The financial media feasts on narratives about interest rates.
This is particularly true in rising interest rate environments where financial conditions tighten and investors get nervous. Endless hours of content are created by trodding out experts who all have different opinions on what rising interest rates mean for investors and if or when you should sell your portfolio.
All this commentary works under a few basic assumptions:
That rising interest rates automatically means stock prices will go down.
That you can prevent losses by listening to their advice.
Let’s look at the evidence to see if these assumptions hold water.
Which “interest rate” are we talking about?
Specifically, the interest rate that impacts the stock market is the federal funds rate set by the federal reserve. The federal funds rate is the rate at which the federal reserve suggests banks borrow and lend money from each other.
Why does the federal funds rate matter?
The federal funds rate is important because it impacts the rate at which banks can borrow money and lend money. If the overnight rate rises, the cost of borrowing for banks rises. Banks will pass along this increased cost of borrowing to consumers and businesses to the extent they can.
Investors worry about rising interest rates because they fear that rising rates will lower the valuation of stocks. Put simply; investors worry rising rates will bring stock prices down.
What does the data say?
Researchers at Dimensional fund advisors looked at how U.S stocks performed in months when the federal funds rate changed from 1983–2021. There was a fairly even split in months where rates increased (70) to months where is decreased (67).
Here’s how the stock market performed.
Months where rates increased → 1.05%
Months where rates decreased → 1.17%
Months where rates did not change → 1.02%
On average, U.S stocks performed better in months where rates increased compared to months where rates remained unchanged. While months, where rates decreased, had the best performance, these results provide strong evidence against the narrative that rising rates will automatically lead to lower stock returns.