Strategising Your Investment Portfolio in a Changing Interest Rate Landscape August 29, 2024
Understanding how to navigate a changing interest rate environment is crucial, as interest rate movements can significantly impact market dynamics. Over the past two years, we’ve experienced a cycle of rate hikes, starting from near 0% in early 2022 to a current risk-free rate of 3% to 4%. This shift has led to substantial inflows into deposits and short-term savings. However, with market sentiment now expecting rate cuts in 2024, it is essential to strategise your portfolio to adapt to this evolving landscape. Here are some key reasons why adjusting your portfolio is important as interest rates peak and are likely to decline soon.
Interest Rates Affect Asset Class Performance:
To make informed investment decisions, it’s important to first understand how different asset classes perform under various interest environments. Typically, bonds and equities have an inverse relationship with interest rate movements. When the risk-free interest rate rises, both bonds and equities tend to decline in value. Bond prices typically decline because their fixed coupon payments become less attractive compared to new bonds issued at the higher rates. Equities also tend to fall as higher interest rates can reduce the present value of future earnings, and raise borrowing costs, which can squeeze corporate profit margins and affect returns to investors. Conversely, when interest rates fall, both bonds and equities generally perform better as investors shift away from low yield cash options, in search of higher returns elsewhere. With potential rate cuts on the horizon, increasing your portfolio allocation to bonds and equities may be a prudent strategy to enhance performance – if these investment instruments align with your risk profile.
Implementing Effective Duration Management:
In a high-interest rate environment, short-term savings, bonds, treasury bills, and fixed deposits are popular instruments for parking liquid funds temporarily. However, when interest rates drop, reinvesting at comparable yields becomes challenging, creating reinvestment risk for those holding too many short-term assets. To mitigate this risk, it’s advisable to shift towards longer-dated savings and bonds to lock in higher yields for an extended period, provided the funds are not needed for short-term financial goals.
Focusing on the Real Interest Rate Rather Than the Nominal Interest Rate:
When interest rates in traditional saving accounts are low (~ 1%), many avoid holding excess cash due to minimal returns. However, if rates were at 3%, investors might jump to this seemingly more attractive opportunity. However, the key consideration is the real interest rate return which accounts for inflation. For instance, if the nominal interest rate is at 1% and inflation is at 2%, the real return is -1%, which means the value of savings is actually decreasing. Similarly, with a 3% nominal interest rate and 4% inflation, the real return is still -1%. Thus, even with higher nominal rates, parking too much in savings can erode your fund’s value. Thus, investment decisions should always focus on the real interest rate return and whether it aligns with your risk profile.
To Construct a Holistic Investment Portfolio:
In any interest rate environment, it’s essential to view your investment portfolio holistically. Asset allocation should align with your specific investment objectives and risk tolerance. A holistic investment portfolio is not solely about achieving the highest potential return but ensuring the portfolio meets target returns while managing risk within your comfort zone. The investment time horizon is also vital. Investors should always focus on overall portfolio allocation and not just individual holdings.
In conclusion, interest rate movements significantly impact portfolio returns. Regular portfolio reviews are essential to ensure your investments are well-positioned to navigate the ever-changing market landscape.
Contributor:
Louis Koay
Senior Financial Services Director
Phillip Securities Pte Ltd (A member of PhillipCapital)
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About the author
Louis Koay
Senior Financial Services Director
Louis Koay is a dual-licensed representative at Phillip Securities Pte Ltd. He is also a trainer at Dr Wealth. A graduate from the National University of Singapore with First Class Honours, he is a CFA charterholder as well as a Certified Financial Planner. He is currently managing a team of 25 advisors and serves more than 5,000 clients with assets under servicing exceeding S$280 million. Louis is the creator and trainer of the Personal Finance Fundamental Course, and the co-trainer for the Intelligent Investors Immersive Program. He has trained more than 20,000 retail investors in stock analysis and personal financial planning.
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