Why Higher Interest Rates Shouldn’t Prevent You From Investing.

Wherever you are in life's journey, it's an excellent time for you to make intelligent financial decisions.

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This year, interest rates reached their highest level since 2007 and are expected to stay relatively high through 2024. This higher-rate economic environment brings excitement but also confusion. You may be asking, “with all of the compelling ways to earn more on my savings, are equities worth the risk?” Thankfully, we have decades of data to help us answer this question. And it may surprise you that the analysis shows it would be foolish to forego equities.



A brief review of interest rate policy

If you’re one of the many people who came of age during the Great Recession in 2008, rates have been low for as long as you can remember. However, the recent zero-interest rate environment is an anomaly when looking back over the past 50 years. From January 1973 through December 2007, interest rates were above 4.00% more than 80% of the time! The less prevalent periods when rates dipped below 4.00% occurred following financial instability: after persistent higher inflation from 1992 to 1994 and after the burst of the dot-com bubble from 2001 to 2005. Rates have gone to zero only twice in the past 50 years: 2008 after the Great Recession and 2020 after COVID-19. So, as you can see, we can analyze many previous high interest rate periods to understand how different saving and investing strategies performed historically.

What history teaches us about investing through different interest rate periods

Although hindsight cannot predict the future, it illuminates why we assert that equities retain a crucial position in a diversified portfolio, irrespective of the allure of high interest rates. To demonstrate this, we analyzed the performance of equities compared to bonds and high-yield savings rates across various time horizons and scenarios. The outcome of our analysis underscores the wisdom of not abandoning equities in the long term, regardless of prevailing interest rates.

Our initial analysis delves into the performance of equities, bonds, and high-yield savings rates over the past 50 years (from June 1, 1973, to May 31, 2023). As illustrated in the accompanying graph, over an extended time frame, equities consistently and significantly outperform bonds, which, in turn, consistently outperform high-yield savings rates.

In our analysis, equities were represented using the US total market returns series from Ken French’s website, encompassing both large and small-cap US stocks. Bonds were portrayed using 5-year Treasury returns due to their medium time frame, and the high-yield savings rate was represented using 1-month Treasury returns, a widely accepted measure of the risk-free rate. It is crucial to note that consistent data sources were maintained throughout the analysis for equities, bonds, and high-yield savings rates.

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Given the key principles of investing, this outcome shouldn’t be surprising.

A fundamental principle of investing is that for higher risk you have the potential for more reward in the long run. Since high-yield savings accounts are on the lowest end of the risk spectrum in our analysis, followed by bonds offering a medium amount of risk, and equities offering a higher amount of risk, we would also expect the long-term returns to follow that pattern.

How does performance vary between low vs. high-interest rate environments?
The analysis examines the average annualised returns for stocks, bonds, and high-yield savings over the past 50 years. The findings demonstrate that regardless of the interest rate environment, equity returns consistently outshine bonds, while bond returns surpass those of high-yield savings rates. The margin of return for equities over bonds and bonds over high-yield savings rates remains consistent in both high and low-interest rate periods.

The graphs below show the average annualized return over these High and Low-Interest Rate Periods for stocks, bonds, and high-yield savings in the past 50 years.


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It’s clear from this analysis that regardless of whether it was a period of low or high interest rates, on average, equity returns were significantly higher than bonds, and bond returns were considerably higher than high-yield savings rates. When saving rates increased, bonds and equities moved higher as well. The margin of return for equities over bonds and bonds over high-yield savings rates remained similar in both high and low-interest rate periods, with equities outperforming bonds by about 4%, and bonds outperforming high-yield savings rates by more than 2%.


Do higher interest rates mean the end of the 60/40 portfolio?
In contemplating the potential demise of the 60/40 portfolio during periods of rising bond yields, our analysis contradicts this notion. The 60/40 portfolio consistently outperforms portfolios that adjust allocations based on interest rates, proving the resilience of this traditional investment strategy.

To quantify the impact of foregoing equities, our analysis focuses on scenarios over the past 30 years, evaluating the financial outcomes of varied allocations to equities, bonds, and high-yield savings. The results underscore that neglecting equities over three decades could result in substantial missed opportunities, while an exclusive focus on equities introduces heightened volatility and risk. To put this analysis in €uro terms, we compared 30-year portfolio return scenarios for investors who we assumed deposited €500 on the last day of each month between May 31, 1993, and May 31, 2023.

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Our analysis shows that the 60/40 portfolio comes out ahead even across higher interest rate periods, and investors who chose to upweight bonds would have lost out on nearly €55,000.

How could foregoing equities impact your wallet?
The above analysis makes it fairly obvious that long-term investments in US equities outperformed 5-year Treasury bonds even in high interest rate periods. Ignoring equities over 30 years could cost hundreds of thousands of euros in missed opportunities. But by going all in on equities, you’re opening yourself up to much more volatility. It’s important to view returns in the context of risk.

We all want our money to earn more for us, but how much risk is worth it for the extra reward?

The principles of diversification, risk management, and aligning asset classes with specific goals have consistently proven effective. Regardless of short-term market volatility or headline-induced impulses, these time-tested strategies remain invaluable. Thinking long-term and resisting the allure of immediate market dynamics is crucial

As we’ve said before, it’s important to think long-term and not let near-term market volatility or headlines influence your strategy. Even as an investment professionals, we sometimes find it hard to escape behavioural finance traps, whether it’s seeing the highest bond yields in years or noticing the volatility in my portfolio. But years of analyzing investment data have shown me that the principles of diversification, managing risk, and using the right asset classes according to your particular goals are time-tested strategies for a reason: they continue to prove themselves again and again.

How to save and invest according to your goals
For individuals seeking to grow their wealth in alignment with their financial goals, the strategic use of cash, bonds, and equities is essential. The allocation of risk should be considered relative to the time horizon of financial needs. Short-term savings are best preserved in a high-yield cash account, while bond ETFs prove ideal for goals in the 1-3 year range. For long-term wealth building, a diversified portfolio of equities is recommended, personalized to individual risk tolerance through Wealthfront’s Automated Investing Account.
Additionally, for those inclined towards a do-it-yourself approach, Wealthfront’s Stock Investing Account offers the opportunity to invest in individual stocks with fractional shares and zero commissions. The comprehensive suite of accounts provided by Wealthfront is designed to support individuals in building long-term wealth across various market conditions.

Written by Pat Leahy, Certified Financial Planner

Published 2023/12/14

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