Novice Investing - Higher Interest Rate, Lower Return

Date: Thursday 20th 2008f November 2008 06:06:06 AM

Higher Interest Rate, Lower Return - 06/16/2006

By: Novice Investing Staff

This article title basically says it all. When you interest rate is trending higher, investors should expect lower return for their stock investment. Fair value calculation is then adjusted in accordance with the rise and fall of interest rate. In 2003-2004, interest rate hovers at 1%. Today, the federal reserve is on the verge of raising interest rate above 5 % for the first time in five years. Bond rate is rising in the 5% range, versus 4.5% last year. All in all, your price earning ratio for fair value of a stock will decrease due to this shift.

Still not clear what a rising rate will do to your investment? Here is an example. In 2003, you have a stock A yielding 5 % or a Price Earning ratio of 20. In a 1% interest rate environment, 5% yield is a wonderful investment. Fast forward today, your stock A is still yielding 5% while interest rate has gone through the roof. Recent indication shows that interest rate is pegged at 5%. You can even buy a 10 year government treasury with that same yield. Common sense tells you that your stock A is less attractive than the government treasury. What would happen? You either sell your stock A, or other investors will! They too do not like getting the same return as the safer government treasury.

Stock is more volatile and risky. Why should they get the same return while taking the additional risk? Thus, your stock A tanks until its price gets low enough for an attractive return. When your stock A drops to, say, 50% below current price, it might get attractive again to some investors. Assuming the same earning power, a 50% drop will give investors a 10 % yield when investing in stock A. Compared to a 5% interest rate, stock A would seem to be a better investment alternatives, despite the additional risk. Some people would even be happy with an 8% yield and start buying stock A before it drops 50%.

So, you see, in a rising interest rate environment, stock price generally declines. You have to know this fact before investing in a seemingly well-run companies, only to find out the truth. As always, education is your best hedge against risk. Or perhaps, a 5 % interest rate starts to appeal to you as a risk averse investors. You should consider checking your local bank's CD rate at bankrate

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Disclaimer: The sole purpose of this article is educational. This article is merely the opinion of the writer and is not in any way a buy/sell recommendation regarding any securities.

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