Inflation… it looks like it’s coming, and if it does, it’ll probably affect you directly in some way.
There are a lot of reasons why prices rise. Lately, that list could include materials being in short supply, and society rising from under the Pandemic, along with a host of other possible causes. Most lead to greater demand, which leads to rising prices (inflation)
One way to slow demand and control inflation, is to increase interest rates. When interest rates rise, it makes purchasing things like homes and automobiles more expensive, thereby tamping down demand and bringing inflation down.
Aside from life being more or less expensive, rising interest rates can directly affect you if you have a 401k, IRA, or any other type of investment, particularly if you have bonds or bond funds.
Rising interest rates drive down the value of bonds already in the market.
That means that when interest rates go up, the value of your bonds go down.
Here’s one of the better ways to explain why…
You go into a bond store and pay $1,000.00 for a 30 year bond with a 10% interest rate. Five years go by and suddenly you have reason to sell your bond. If the current interest rates are still 10%, you can probably sell your bond for the same price you purchased it… $1,000.00. However, if interest rates have since gone up to 20%, no one’s going to want to purchase your bond for $1,000.00 at 10%, when they can pay the same thing for a 20% bond. So you have to lower the price of your bond to a point that makes sense to the purchaser. Interest rates go up... existing bond values go down.
Why write an article about this now? Because inflation is beginning to rise. Whether it continues or not is yet to be seen. But if it does, interest rates will probably rise also. Most people have a mix of stocks and bonds in their portfolio. If interest rates rise to combat inflation, that can affect the bond funds you have inside your 401k, IRA, or other investments.
Now would be a good time to reassess your ratio of stocks to bonds. You may also want to examine the average duration of your bond funds, which can give you an idea of how much principle your funds will lose as interest rates rise.
It’s always a good idea to keep an eye on your portfolio and assess the various risks, as they pertain to what’s happening in the world at the moment. But every so often, there is even more reason to do so. I believe this is one of those times. Back on April 5th of this year, Financial Concepts Unlimited, LLC reallocated all its’ managed accounts for this reason. Not necessarily because of a big fear from inflation, but because interest rates were so low, there was a greater chance of them rising than falling, and therefore the thought was that bonds carried more risk than stocks at the moment. I still think that, and thus far, that reallocation has paid off nicely.
None of this means you shouldn’t have a good mix of bonds in your portfolio. They’ll probably make you glad you have them some day. All of our portfolios, except for the most aggressive, have varying percentages of bonds in them. But it is a good idea to reexamine their duration, and your ratio between stocks and bonds. Not only now, but on-going. But yes… now would seem to be a pretty good time to start, if you haven’t been doing so.
If you have any questions, always feel free to ask. We're always glad to answer your questions or help in any way we can.