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Fed Rate Hike: 4 Ways to Ride Rising Interest Rate Wave

March 15, 2017
Investing, Investing Strategy, Retirement Planning
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The Federal Reserve has delivered on its promise. The central bank announced Wednesday it will raise interest rates, putting it on track for three expected increases this year.

At the conclusion of its March 15 meeting, the Federal Open Market Committee voted to raise the federal funds interest rates by 0.25 percentage point, to a range of 0.75% to 1%. This marks only the third increase since the financial crisis and comes just months after a move in December.

This rate hike was all but guaranteed on Wall Street, so much of the impact already has been priced into the market and you may not see a huge change. But the important takeaway is policymakers deem that the U.S. labor market and economic outlook are strong. Or as Fed Chair Janet Yellen said three months ago, “It is a vote of confidence in the economy.”

If you’re new to investing, this may be the first time you’ve experienced a rising rate environment. After all, the Fed hasn’t been regularly using this tool of monetary policy since mid-2006.

Here are four investing tips in anticipation of higher rates to come:

1. Consider tweaks, not an overhaul

There’s a Wall Street mantra, “don’t fight the Fed,” that surfaces at times like this. It suggests you should accept the Federal Reserve’s monetary policy decisions and align your portfolio to benefit from such changes, rather than fighting them.

That doesn’t mean a complete overhaul is warranted. Why not? First, professional investors already have driven up the prices of stocks that will benefit from higher interest rates. In essence, you’re a bit late to the party. Second, upending your current investment strategy could cost you now and later, especially if you need to reverse course when the Fed cuts rates again.

Instead, ask yourself a key question: Do higher rates affect your long-term expectations for any investments in your portfolio? If so, some tweaks may be warranted. Any changes should be done in the spirit of your original investment thesis.

No matter what the Fed is doing, a well-diversified portfolio that includes investments across and within assets will help you hedge against unforeseen risks, or even well-telegraphed changes like rate hikes.

2. Boost your retirement savings

As interest rates go up, banks will charge borrowers more for mortgages, credit cards, auto loans and student loans. In theory, they’ll also increase rates for savings accounts, but such changes could be modest.

Instead of dreaming of 2007-era 5%-plus savings-account offers, you’re better off investing surplus money for retirement (after paying off high-interest debt and establishing a rainy-day fund, of course). First, make sure you’re getting your 401(k) match from your employer, then consider an individual retirement account.

Here you have two options: a traditional IRA or a Roth IRA. The difference comes down to how and when you get a tax break. With a traditional IRA, your contribution is tax-deductible, whereas the benefit of a Roth IRA is your withdrawals during retirement aren’t taxed.

While the maximum for either type of account is $5,500 in 2017 (though Roth IRAs have eligibility rules based on income), you may be surprised by how a little extra savings can add up for retirement.

3. Pay some attention to bonds

Bonds don’t get the same love as stocks. They’re not high-fliers, they don’t grab headlines, and they can be confusing. They’ll also be directly impacted by higher interest rates.

As rates go up, the market value of bonds typically goes down. That’s because if you try to sell that bond, it will be competing with newer bonds that offer a higher return. And the longer the bond’s maturity (usually measured in years), the more likely its value will take a hit when interest rates increase.

While higher rates will make bonds attractive down the road — you get to lock in money at a guaranteed rate for a specific time period — this is where you could feel the sting of rising rates.

“For individual investors, higher interest rates in the long term are welcome news, but the problem is, getting there could be painful,” says Jack Ablin, chief investment officer of BMO Wealth Management in Chicago. “Look at your fixed-income holdings and make sure you don’t have too many rates locked in for long maturities.”

Not sure you own bonds? Well, you should; they help balance out risk from more volatile assets like stocks and should become a bigger part of your portfolio as you approach retirement. Bonds are a standard offering of 401(k) plans and are included in target retirement funds. They’re also popular short-term investments because of their relatively low-risk and fixed-income returns.

Bonds are an important component of a well-diversified portfolio, but with rates at still-low levels, you shouldn’t tie up a lot of money there just yet. And when given the option, invest primarily in bonds (or bond funds) with low expenses and shorter maturities.

How does that work? If you’re investing in a bond fund, say in a Roth or traditional IRA, choose ones with shorter maturity date (one- or two-year, for example), rather than, say, 30-year Treasuries. This will prevent you from losing so much money as rates rise. Or consider certificates of deposit, particularly for money you plan to tap within the next few years. These accounts have even shorter terms, and you can build a ladder to benefit from rising rates.

4. Keep the Fed in context

The latest rate hike shows that policymakers have confidence in the U.S. economy’s strength. This marks a “sweet spot” for investors. Such increases are justified by economic reports but are far from sending alarms about whether too-high rates will constrain growth, says Bruce McCain, chief investment strategist at Key Private Bank in Cleveland.

As a result, investors are free to focus on other things. “The market is reasonably happy with what it’s seen with economic statistics and more importantly, new policies coming out of Washington,” McCain says. “The Fed has become something of a sideshow to the Washington show.”

The market’s got more on its mind than the Fed — and so should you. The return of this type of monetary policy will likely be a blip on your longer-term investing horizon, and it’s important to understand how it will affect your portfolio without obsessing over it.

Instead, focus on being well-diversified, avoiding rash allocation changes and staying invested — and you can ensure your first experience investing in a rising rate environment isn’t your last.

Anna-Louise Jackson is a staff writer at NerdWallet, a personal finance website. Email: [email protected]. Twitter: @aljax7.