Although saving and investment is based on an investor’s time horizon, risk tolerance, tax situation and liquidity needs, you also can adjust your saving and investment activities for expected changes in interest rates. Saving and investing as a function of interest rates should be based on long-term expectations. It would be too time and labor intensive to react to every short-term interest rate movement, and could possibly result in high transaction costs as well as rapidly diminishing marginal returns on your efforts.
If you are a long-term investor, rising interest rates generally will negatively affect the equity portion of your portfolio, which also likely would be your portfolio’s dominant asset class. This could result in greater opportunity costs associated with the equity portion of your portfolio if, say, yields in other asset classes rise while overall returns on equity securities fall. The proliferation of exchange-traded funds provides a number of alternatives to remain heavily invested in equity securities while shifting to funds geared toward different interest-rate expectations.
If interest rates begin trending upward, one strategy is to keep the duration of the fixed-income portion of your portfolio as short as possible, investing in CDs and other short-term, fixed-income securities. This will enhance liquidity while allowing for reinvestment in progressively higher-yielding, fixed-income securities as rates increase. If you feel uncertain regarding interest rate expectations, you may choose to invest in specific fixed-income securities with the knowledge that if you hold on to the bond through its expiration date, there is a very strong probability that you will receive the full stated coupon yield, regardless of interest-rate fluctuations.
You should already have a diversified portfolio of stocks and bonds calibrated to your investment time horizon and risk tolerance, while also maintaining an appropriate level of liquidity. Available liquidity is a good safety net; it's also smart to have funds ready to make investments based on wide market swings. In a low interest rate environment, you may be able to use available liquidity to explore alternative asset classes that generate higher yields. Think of interest rates as the cost of holding money, and as interest rates rise you can seek out higher risk-adjusted returns.
One form of risk management is to match the durations of your assets and liabilities so that as specific debts come due you will have investments reaching maturity, releasing funds to be used to pay down those debts. This would require the ability to calculate future values of investments based on expected annual returns, particularly if your debt is accruing at a different interest rate. Another form of risk management is to perform a basic value-at-risk calculation by estimating the amount your portfolio could potentially decline based on certain hypothetical interest rate movements.
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