(Meet me at the Real Estate & Entrepreneurship Conference for Physicians September 26-28, 2024 in Dallas Texas. Send me a message if you are coming so we can meet up. I would love to meet you in person. Today’s guest post comes to you from David Rosenstrock, who is a certified financial planner with an MBA and the Founder of Wharton Wealth Planning, LLC.)
Higher interest rates are mostly positive, but investors need to watch out for pitfalls, too.
Two years ago, yields on 10-year Treasury bonds were below 2%. They’ve more than doubled since then, as the Federal Reserve hiked interest rates 11 times to bring inflation back down to historical averages. Long-term government bonds yielded 1.90% at the end of 2021 and currently yield about 4.4% — a dramatic increase in yield over a short period of time, especially after the extended low-yield environment we have experienced since the financial crisis of 2008-2009.
Higher interest rates raise the long-term return prospects for bonds and other short-term assets, meaning that investors can earn higher returns without moving into riskier asset classes, such as stocks.
But higher yields also bring potential pitfalls:
Being Complacent with Cash Holdings– If you’re in a low-yielding cash account, your investment provider won’t automatically move you into a higher-yielding option. You need to check your interest rate to ensure it is attractive relative to the market.
Over-allocating to Conservative Investments– Certificates of deposit, money market funds, and I Bonds, have been very popular investments recently. It is easy to become attracted to the certainty these investments offer. Still, it’s also important to recognize that the current higher yields on these investments can go down over time. This can leave you with limited options to reinvest the cash in the future, ultimately lowering your long-term returns. This type of risk is known as reinvestment risk.
Forgetting about Taxes– Investors need to also keep in mind that CD’s (short and long-term) are generally taxed at ordinary income rates and this can eat away at a lot of the stated or advertised yield an investor expects to receive.
In comparison, for example, long-term capital gains taxes associated with stocks (held for longer than one year) are lower than an investor’s ordinary income tax rate. So, you should look at after-tax returns when assessing a CD versus other investment opportunities.
Forgetting about Inflation– Another way that today’s yields can be tricky is that they don’t reflect the corrosive effects of inflation on whatever payout you’re able to earn. Cash investments usually keep pace with inflation—but barely. Other asset categories generally compare more favorably here. The concept of real yield refers to the rate of return that a fixed income investor earns from interest payments after factoring in (or subtracting) the inflation rate.
Trying to Get the ‘Most’ Yield– Investors that prioritize yield over total return and risk adjusted returns can get themselves into trouble (see an article on bond investing we contributed to here. https://fortune.com/recommends/investing/how-to-buy-bonds/).
Ignoring Asset Location– The type of account you use (taxable, tax-deferred, etc.) to hold income-oriented investments can make a big difference to your returns.
Asset location means that you want to hold your assets in different types of accounts from a tax perspective. Asset location can make a meaningful difference in the taxes you pay over time and it is important to match different types of accounts (i.e. taxable, retirement, etc.) with particular investment strategies.
You can hold investments in tax-deferred accounts (e.g., Individual Retirement Accounts or IRAs), taxable accounts, or tax-exempt accounts (e.g., Roth IRAs). Paying attention to asset location can improve your portfolio’s after-tax returns and allow you to keep more of what your investments earn. Considering which account should hold which investments is an important strategy, but one that is often overlooked. It can help investors with both taxable and tax-advantaged accounts reduce their taxes.
Not Being Vigilant with Asset Allocation– Generally, we recommend a combination of stocks, bonds, and, in certain instances, cash or cash-related investments. The right percentages and investment selections should be customized depending on your situation and circumstances. Asset allocation (and diversification) are two of the most important factors regarding your long-term investment returns and success.
Higher interest rates increase an investor’s expected purchasing power for the long term. This is especially true if inflation continues to decline back to historical averages. However, it is important not to lose sight of the forest for the trees.
Editor’s notes: Have you ever had a conversation with your banker and discovered they have a new account that will better suit your needs and earn a higher interest rate than your current account? I have, and I hate it when I find out they have had this “new” account for two years and didn’t bother to inform me of their better deal. They never tell you they have a new better deal. You must walk in and ask about it. Once a year it might help you to sit down with your banker and ask them if you have the best account for your situation.
David Rosenstrock, CFP®, MBA, is the Director and Founder of Wharton Wealth Planning (www.whartonwealthplanning.com). He earned his MBA from the Wharton Business School and B.S. in economics from Cornell University. He is also a CERTIFIED FINANCIAL PLANNER™.
