The rise and fall of interest rates is one of the biggest factors influencing the economy and financial markets. It is important to have a basic understanding of how interest rate changes affect your pocketbook and investment portfolio.

Typically the Federal Reserve lowers interest rates to jump-start the economy. Lower interest rates mean consumers may be willing to spend more money and incur more debt. This stimulates the economy in a variety of ways, including increased revenues from products sold to the consumers and taxes generated from those sales. Investors, on the other hand, have a different perspective.

Bond Investors: As interest rates fall, the prices of previously issued bonds tend to rise. The new issues are offered at lower, less appealing rates. That makes bonds with higher interest rates much more desirable and that much more in demand.

On the other hand, those who plan to hold their bonds to maturity aren’t really affected by falling rates, with the exception of reinvestment risk.

One way issuers may take advantage of falling rates, is by calling their outstanding bonds and issuing new bonds at lower rates. This can hurt those whose bonds have been called because they can’t reinvest at the rate they were previously receiving. To offset that risk, it’s important to make sure you don’t have too many callable bonds in your portfolio. Your fixed-income investments should be diversified to withstand rising and falling rates.

Stock Investors: Falling interest rates tend to have a positive impact on the stock market, especially stocks of growth companies. The companies that tend to borrow money to finance expansions also tend to benefit from declining rates. Paying lower interest rates decreases the cost of their debt, which may positively affect their bottom line. The stock prices of those companies may rise as a result, driving the market in such a way that prices of other stocks may follow suit.

When the Fed decides to raise interest rates, its goal is usually to slow down an overheating economy. The cost of borrowing increases, and consumers may begin to cut back on spending. This reverses the effects that lower interest rates had on the economy and, again, investors are affected differently.

Bond investors: When interest rates shoot up, the demand for bonds with lower interest rates typically falls, which decreases their value. That’s because new bond issues are offered at higher rates.

Stock investors: Depending on the current market environment, rising interest rates can have a positive or negative impact on the stock market. In some cases, rising rates can send jitters through the market, resulting in falling stock prices. In other cases, the stock market will respond favorably.

In addition, rising interest rates may affect certain industry groups more than others. For instance, because growth companies borrow money in order to expand, rising interest rates increase the cost of their debt, which in turn decreases profit (or increases loss). As a result, the prices of their stocks may fall.

If you’re interested in learning more about what changing interest rates mean for you, a financial advisor can help you better understand the effects interest rates may have on your portfolio.

Understanding the Language of Investing

Stocks and bonds could probably be considered the basic building blocks of an investment portfolio, and you’ve most likely heard of them before. But beyond just these two basic terms there is a whole world of investment opportunities, and sometimes the financial world seems to have a language of its own. Fortunately though, there are many resources available to help you understand what it all means. To get you started, let’s discuss a few of the most common terms you might hear and what they mean to you.

• Asset Class — a term used for categorizing different types of investments. There are basically three asset classes: stocks, bonds and cash.
• Asset Allocation — the process of selecting and blending investments from different asset categories to reduce investment risk and reach long-term investment goals. This refers to how much of your money you put into stocks, bonds and cash equivalents (such as checking accounts, money market funds and CDs). Proper allocation keeps your money spread over different types of investments, so if one particular type is struggling, the other types could still be doing well.
• Diversification — the process of deciding what mix of investments to own within each asset category. After you have determined the proper asset allocation for your investments, diversification helps you spread your investments out even further. Owning stock in companies from a wide variety of industries, for example, puts you in position to see possible benefits from moves in different sectors of the economy.
• Dividend — when a company decides to share profits with investors, it usually pays a dividend to stockholders. The company’s board of directors decides when these payments are made, and how much they’ll be, but typically dividends are paid on a quarterly basis in the form of cash or additional stock in the company.
• Commodity — as opposed to stocks and bonds, which are simply valuable pieces of paper, these can include tangible products that are traded on an authorized commodity exchange. There are many different types of commodities, including agricultural products, metals, and petroleum. Foreign currencies and financial instruments and indexes can also be considered commodities.

Hopefully now you have a little better understanding of some of the basic terms associated with investments. In addition to knowing about these options, it may be helpful to know where you can find some of these investment vehicles. Rather than just going out and searching, there are many markets and systems set up to help investors with the process of buying and selling:

• Exchange — a system for the organized trading of securities. There are several major exchanges in the United States, including the New York Stock Exchange, American Stock Exchange and Chicago Board Options Exchange. Several regional exchanges throughout the country also trade securities.
• Over-the-counter (OTC) — a highly sophisticated communications network on which dealers trade securities that are not listed on any exchange. All government bonds and all other non-listed stocks and bonds are traded on the OTC network.
• Nasdaq — an electronic information network that provides brokers and dealers with current price quotations on many actively traded over-the-counter securities.

While understanding these terms should help give you a good start, there is plenty more to learn about the world of investments. Another great way to educate yourself is to speak with someone who is well versed in the language. A financial advisor can take the time to explain what everything means, and help you make decisions about how to meet your own personal needs.