Personal Finance, Money and Investing

Investing With Declining Interest Rates

Posted on November 6, 2007 in the Investing, Money category

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The Federal Reserve has lowered interest rates twice in the last two months. While that is good news if you have an adjustable rate mortgage or line of credit, is it good news if you own stocks? The answer to that is maybe!

In three of the past four rate-cut cycles, stocks actually fell in the six months following the first drop in rates. Sam Stovall, chief investment strategist for Standard & Poor’s, points out that following the first Fed rate cut in 1990, stocks sank nearly 14%.

Falling interest rates can add some volatility to the stock market, making this an uncertain period for investors with highly aggressive portfolios. Employees in 401(k) plans recently held nearly 70 percent of their accounts in stocks, marking their biggest bet on equities since July 2001, according to Hewitt Associates. And, many of those portfolios have gravitated toward some of the riskiest types of stocks.

Ultimately, you want an investment portfolio that will allow you to sleep at night. In times of market volatility like these, it is sometimes prudent to trim your portfolio of the it’s more aggressive sectors. Three ways to do that are:

1. Change the types of stocks you own, not the amounts
After several years of big gains in riskier types of equities, “the average investor is probably overweight emerging markets and small-cap stocks,” says Richard Bernstein, chief investment strategist at Merrill Lynch. By reducing your exposure to these types of stocks, while shifting to more stable investments like blue-chip companies you can maintain your overall equity stake while smoothing the ups and downs in your portfolio.

2. Change the types of stocks you own and invest in less risky funds
For a smoother-than-average ride, you can start by focusing on dividend-paying stock funds to satisfy your large-cap stock allocation. Why? Since 2002, stocks in the S&P 500 that pay out dividends have fallen about a third less than stocks that don’t.

3. Change your stocks and reduce your overall exposure to equities
If you’re really having trouble sleeping at night when the market tumbles, you may want to take a more drastic approach by reducing your overall exposure to equities. Certainly, such a move would mitigate potential for losses should the market continue to slide. For example, by going from an aggressive 80 percent stock-20 percent bond portfolio to a 60-40 mix your worst short-term losses would have been cut in half over the past 10 years.

The downside is that this type of strategy will also trim your long-term gains. In this case, a 60-40 strategy would have cost you about 0.3% points a year for the past decade.
To some people that is a pretty steep price to pay for peace of mind. For others, it is not. It all depends on your risk tolerance level. But it is much better to readjust your portfolio allocation than to jumping in and out of the market or shifting your investments to cash whenever stocks take a dive.

Here is how a typical portfolio could be adjusted to take some of the market volatility out of it, without sacrificing much in the way of performance.

A Typical 80%-20% Investment Portfolio:
This type of portfolio has a 10 year average return of 8.4% per year. Over the last ten years, its worst three month performance is -17.8%

The 80% in stocks is typical invested as follows:

The 20% in bonds is typically invested as follows:

A more conservative 60%-40% Investment Portfolio:
This type of portfolio has a 10 year average return of 8.1% per year. Over the last ten years, its worst three month performance is -8.8%

The 60% in stocks is typical invested as follows:

The 40% in bonds is typically invested as follows:

How have you adjusted your investment strategy with the recent market volatility?


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