When it comes to deciding which mutual funds to choose and invest in, the biggest factor that comes into play is the economic health of the nation and the world. And the most important indicator of an economy’s health and investing environment is its interest rates. So if someone advises you to put your money into a particular stock, bond, or money market mutual fund, don’t race off and do it without performing a little research.
That’s because current market interest rates and the direction they are heading will signal which one of these investment categories will deliver consistently higher returns than the other two. This is what I call the Money Shifting Strategy.
In this article, you’ll learn the importance of interest rates, and how to use them to choose the right mutual fund category at any given time.
First, let me say that what I’m about to tell you isn’t something new that I invented. The role and impact of interest rates on investment decisions is well established. And while there are exceptions to every rule, these guidelines will serve you well if you stick to them.
Importance of Interest Rates
If you watch the news every now and then, you’ll hear the newscaster mention something about the Federal Reserve or Federal Reserve Bank in a discussion about our economy. The Fed, as it is often called, is our nation’s central bank and there are actually 12 regional bank branches that make up the Federal Reserve System.
The Federal Reserve is responsible for controlling interest rates, overseeing the printing of money, and a number of other very important things. Many people think that the President runs the economy, but that’s simply not true. That job rests in the hands of the Fed.
So as the Fed watches over the economy, it monitors all kinds of business activity such as home and auto sales, manufacturing output, and orders for different types of goods and services. By monitoring this activity, the Fed can determine if problems like inflation or a recession are around the corner.
If it sees something bad on the way, one of the tools that it uses to get things back in balance is a key interest rate called the Federal Funds rate. This is the borrowing rate that regular commercial banks charge when loaning money only to each other. Yes, banks can have temporary cash shortfalls, too. And the rate is periodically raised or lowered by the Fed as certain economic events unfold.
So anyway, with the Federal Funds Rate as a guide, the country’s largest commercial banks will agree on a higher minimum interest rate that they will charge you, me, and other businesses to borrow money. This rate is called the Prime Rate. Check out the chart below for the rates that banks and businesses pay close attention to.
Of course, banks have the flexibility to charge rates even higher than the Prime Rate. And so in the name of more profits, they do.
So what does all this have to do with mutual funds, you ask?
Patience, patience….I’m getting there. I just wanted to make sure you have a basic idea of how market interest rates on auto loans, credit cards, etc., are determined. You’ll understand it’s importance shortly.
The Money Shifting Strategy
This strategy advocates that you should shift or move a portion of your money between stock, bond, and money market funds based on certain changing parameters within the economy. For example, let’s examine how interest rates play a significant role in determining which mutual funds to choose and when.
Money Shifting Strategy #1: When to Invest in Stock Mutual Funds
The rule of thumb is that when market interest rates are low, you should shift more money toward investing in stock mutual funds (also called equity mutual funds). Here’s why.
When market interest rates are low, what’s usually happening in the economy?
If you’re not sure, I’ll tell you. This is generally a time when it’s easy to get car loans, credit cards, and other types of loans. So from a consumer perspective, there is a great incentive to buy stuff.
And when consumers are spending freely, what are manufacturers doing?
Well, they are expanding their factories to meet consumer demand for HDTVs, cars, washers, computers, etc. Manufacturers will also feel good about borrowing money from the bank to buy new equipment, create more jobs, and rake in gobs of profits.
Of course, this is also music to the ears of stock traders and brokers. All those good vibrations and profits will cause stock prices to rise and rise. Everyone will want to get in on the action, including stock mutual fund managers.
After all, their mission is to make your porfolio grow in value. That’s why you hired them, right? But the good times never last forever and interest rates eventually rise.
Money Shifting Strategy #2: When to Invest in Money Market Funds
The rule of thumb is that when interest rates rise to the point where they cause the stock market to retreat, you should shift more money toward investing in money market mutual funds.
As I mentioned above, when interest rates are low, there is an incentive to spread money all over the place. That’s a good thing up to a point.
Unfortunately, having all that easy money being thrown around could cause the economy to get overheated. One way this occurs is when companies increase prices on those televisions, washers, and other goods and services in order to pay bigger salaries, hand out fat bonuses, rake in more profits, etc.
If this is done too quickly by many companies, it could cause inflation to set in. The simple definition of inflation is too many dollars chasing a shortage of goods.
Through it’s monitoring program, the Federal Reserve Bank will see the potential for inflation. So, it will attempt to gently apply the brakes to the economy by raising the Federal Funds Rate. This will, in turn, cause the Prime Rate to rise.
When this happens, the rates on loans and credit cards will go up, which will cause some companies and consumers to reduce their spending. Factory production will slow down and the stock market will begin to cool off due to lower future profit expectations.
When considering putting money into money market funds, what you should look for is a sluggish economy, stagnant stock market, and/or a series of increases in the Prime Rate. Also, check the trend in rates paid on money market instruments such as Certificates of Deposit and money market saving accounts. They should be increasing.
So the rationale for shifting from stocks funds to money market funds is this. In general, stock prices tend to flatten or fall as interest rates rise. As such, it would be wise to shift more of your contributions to money market funds which are very safe and low risk, and they will provide a reasonable return on your investment until the economy heals its wounds.
By the way, when I say that you should shift your money around based on changes in market interest rates, I’m not suggesting that you should withdraw all of your money from a particular fund and deposit it in a different fund. I simply mean that you should stop or reduce the amount you’re contibuting to the underperforming fund.
Of course, that doesn’t mean you should ignore the performance of any of your funds. You should set expectations for all of them. And if a fund underperforms for a few years or whatever timeframe you set, then you should dump it. This is especially true if the fund should be doing well according to the rules of the Money Shifting strategy.
Money Shifting Strategy #3: When to Invest in Bond Mutual Funds
The rule of thumb is that when interest rates are high, but are about to start coming down, you should shift more money toward investing in bond mutual funds.
Bonds are debt instruments issued by corporations and governments to finance projects of all kinds, such as a new water treatment facility, bridge, or sports stadium. In essence, when a company or government issues a bond, it is asking you for a loan. So you get to hold the I.O.U.
By and large, bonds are viewed as being very safe and low risk. In gneral, you can expect a return on your investment that is historically lower than stocks but higher than money market instruments.
Without getting into the jargon and complexities of bonds, I’ll provide just enough information to explain why it’s better to invest in them when high interest rates are about to fall.
When you buy a bond, it comes with a fixed interest (coupon) rate and a timeframe for when the principal and interest will be paid to you. If, for example, you invest in a $1,000 bond that will pay you 5% interest one year from today. That means at the end of one year, you’ll get a check for $1050, which amounts to a $50 return on your investment.
But let’s say that after two months go by you want to get rid of your bond early because you need the money. Not a problem. So you go online to investigate how to sell it. But while doing research, you discover that there are now similar $1000 bonds that are currently paying 6% because interest rates in the overall economy are rising.
As you might imagine, the question that will come up is, “Why would someone want to pay you full price for your bond if the 6% bond is a better deal?”
The answer is you’ll probably get offers on your bond that will amount to a small discount or loss. Maybe instead of getting $1050, you’ll have to settle for $990. Plus, there may be additional transaction fees for not holding the bond for the full year.
Now, if the situation was reversed and market interest rates were falling, your higher coupon rate bond would be more valuable. Even if you wanted to sell it early, a prospective buyer would rather pay you a premium for your bond rather than get one with a lower rate of say 4%.
Determining Where You Should Be Investing Money Today
When determining whether interests are low or high, it’s all relative to what’s occurring in the economy now versus the last five to seven years.
So if you’re not sure which type of mutual fund you should be putting your money into right now, then it would be beneficial to view current and historical trends for interest rates and the rates of return on stocks, bonds, and money markets.
Let’s start with the stock market. The chart below shows the annual rate of return on investments for the S&P 500 Index over many years. All you need to know about the S&P 500 Index is that it consists of the stocks of 500 leading companies. The stocks in the index rarely change. In fact, I think a computer probably manages the index.
Mutual fund managers will often compare their results to the S&P 500 Index to determine if they “beat the market” and by how much. So if you ever want to determine how good of a job your stock fund manager is doing, compare his annual returns to this index. You may be (unpleasantly) surprised.
Would you like to guess how many mutual funds outperform the S&P 500? Historically, on average, only about 25% of them annually do better than this index (which is also available as a mutual fund). This means that 75% of the thousands of funds, being managed by top business school grads, are delivering substandard returns.
Okay, back to the above chart. Take a look at the returns over the last 5-7 years. There’s one year that shows a big negative return (loss) of 38.5% and another year where the return was zero. But other than that, the returns are solidly in the positive range.
Next, let’s take a look at the Prime Rate chart below. As I write this, it has remained unchanged for more than five years, since 2008.
So thus far, we have a Prime Rate of 3.25% at historical lows and stock market that is experiencing erratic but reasonably positive returns overall. (Remember: Low interest rates are good for stocks.)
Now, let’s see what the returns are on bonds and money market instruments. First up is the chart for Government Treasury Bonds (3 months to 30 years). The column titled as “Coupon” is the interest that is paid on the bond. And, yes, there are government bonds being sold at 0%.
So what do you think?
You have to be willing to sink money into a 30 year bond just to get a decent return. That might be fine if you’re a very conservative investor and think rates are going lower. But I suspect rates are more likely to go higher in the future. So I’d say it’s pretty clear that the stock market is the better investment option.
Finally, let’s see what rates of return are being offered on money markets. Here they are:
With a pay out of less than 1%, they don’t appear to be performing any better than bonds.
So what conclusion can we draw from our little analysis? Well, its safe to say that interest rates are sufficiently low to encourage investing in stock mutual funds.
In fact, in my opinion, you’d probably have to see a significant downturn in the economy, that lasted for at least a couple of years, before it would be prudent to consider shifting money away from stocks.
Nevertheless, when you get investment advice from people and you’re trying to decide which mutual fund style or type to choose, come back to this article and go through this Money Shifting Strategy. It will help bring clarity to your decision-making process and filter out noise.
|Page 1||Page 2||Page 3||Page 4||Page 5||Page 6||Page 7|