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What Does a Federal Reserve Rate Hike Mean for My Investments?

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone and is not intended to be a source of investment advice. It may not have not been reviewed, commissioned or otherwise endorsed by any of our network partners or the Investment company.

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The Federal Reserve exerts a high degree of influence over interest rates in the U.S. via the federal funds rate, which is the interest rate banks charge one another for overnight loans. The Fed’s Federal Open Market Committee (FOMC) is the body that sets this rate at its eight regularly scheduled meetings.

While the rate banks charge one another for a specific type of loan might seem pretty confined, a change in the fed funds rate can have a ripple effect on the economy. An increase in the fed funds rate increases the cost of funds for banks — a cost they ultimately will pass on to their customers, both individuals and businesses.

An increase in the fed funds rate invariably leads to an increase in the prime lending rate. This is the rate banks charge their most creditworthy business customers. Not only does this make borrowing more expensive for many companies, but many consumer interest rates — such as those on credit cards or short-term loans — may be tied to the prime rate and tend to increase when interest rates rise.

Beyond the obvious impact on borrowers and credit card holders, higher borrowing costs can ripple through the rest of the economy, including to your investments.

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What a Fed rate hike could mean for your investments

Rising interest rates impact most areas of the economy — including your investments. Here’s what to look out for.

Stocks and bonds

Bonds move inversely with interest rates. When rates rise, all things being equal, the price of existing bonds will decrease. Those investing in individual bonds could see the price go down. If the bond is held until maturity, investors will receive the full value of the bond. If they need to sell the bond prior to maturity, they may receive a price that’s lower than it would be if held until maturity.

Bond mutual funds and exchange-traded funds (ETFs) are impacted in a similar way but with a key difference. Since they are portfolios of bonds, the funds themselves never mature. An interest rate hike could reduce the value of the bonds held in the funds.

The impact on stocks, stock mutual funds and ETFs is a bit harder to gauge. Rising interest rates can lead to higher borrowing costs for many companies, which could impact the profits of companies who rely heavily on debt financing.

Rising rates also could hurt the revenue of companies whose business is dependent upon customers’ ability to borrow money, such as automobile manufacturers or homebuilders. Depending on how much stock of these companies you own or how prominently they are represented in ETFs and mutual funds you own, the impact could be adverse.

Real estate

If interest rates rise, the residential real estate market also could be impacted. Higher mortgage rates impact buyers’ ability to borrow. This could serve to decrease the demand for housing, driving down prices. Besides prospective homeowners, this could impact those who invest in income-producing properties.

Similarly, the price of commercial real estate could see a decline if interest rates drive up the cost of loans to purchase commercial property. If financing is harder to get or the cost of borrowing is too high for some buyers, it could serve to drive real estate values down.

Real estate investment trusts (REITs), which own or finance various types of income-producing properties, also may suffer in value in a period of rising interest rates. There are many publicly traded REITs, which are essentially stocks, and many mutual funds and ETFs invest in REITs.

Rates for savers

Savers who use vehicles like CDs, money market mutual funds and other types of saving accounts could see an increase in the interest rate they earn when investing in these types of vehicles and accounts.

This provides a better return on these relatively low-risk savings vehicles. That could give a much-needed boost to investors who keep funds in these types of accounts, whether as a parking place for emergency cash or as a safe spot to stash a portion of their retirement savings.

Retirement savings

Money held in your IRA and 401(k) accounts likely would not be impacted by rising rates, simply because of the structure of the accounts. However, as mentioned above, the investments held in these accounts could be impacted, potentially reducing the value of your retirement savings.

Recent changes in the fed funds rate

In January 2020, the Fed has yet to make any changes to the federal funds rate so far, where it currently stands at 1.50% – 1.75%. Nor is any change — whether a hike or cut — expected to come any time soon. Banks and consumers are still recovering from the Fed’s latest moves: three rate cuts in the second half of 2019. Borrowing and deposit rates have gone down, and continue to do so, as a result.

Here’s what happens after a Fed rate cut.

The last time the Fed raised the federal funds rate was back in December 2018, the last in a string of four hikes that year, leaving the rate range at a high of 2% to 2.25%. The rate rose gradually from near zero in the years directly following the financial crisis of 2007, when the Fed kept rates low to help the economy recover.

Where are interest rates headed in 2020?

It’s generally expected the Fed will keep interest rates on pause for the time being. Fed Chair Jerome Powell has said they would need to see developments in the economy that cause a material reassessment to provoke any change. It is unlikely a development like this would come from within the U.S. economy itself; rather, outside risks like global growth and trade negotiations that weigh the economy down would trigger a Fed move.

With this continued pause, deposit and lending rates also remain in limbo. Several banks continue to cut their own rates, while others hold steady or even raise their rates.

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Stocks vs. Options: Discover Which May Work Best For You

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone and is not intended to be a source of investment advice. It may not have not been reviewed, commissioned or otherwise endorsed by any of our network partners or the Investment company.

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Most investors are familiar with stocks and the stock market. Popular stock benchmarks like the Dow Jones Industrial Average and S&P 500 are widely quoted in the news. The health of the stock market is often equated with the health of the economy.

Stock options are another way to participate in the movement of stocks, and they can offer investors an alternative to direct ownership of stocks. We will look at both stocks and options and discuss how investors might use these tools.

Stocks explained

We hear the term “stock market” on a regular basis. But what does owning shares of a company’s stock actually entail?

Owning shares of stock in a company actually makes the shareholder an owner. This doesn’t mean you can walk into to the company’s headquarters and take over, but it signifies that you have a claim on the company’s earnings.

There are two classes of stock: common and preferred. Not all companies issue preferred shares. Common shares are the shares whose prices generally are quoted in reference to the stock of companies like Apple, Exxon Mobil and others.

Common shareholders have the right to vote at the company’s annual meeting (either by mail, online or in person in some cases) and to receive any dividends paid by the company to common shareholders.

With preferred stock, shareholders have a preference on any dividends declared by the company — meaning these shareholders would receive their payments before common shareholders in the event there would be a problem making dividend payments. Preferred stock does not carry voting rights, however.

How stocks are traded

Stocks are traded during the period when the stock markets are open — for example, from 9:30 a.m. to 4 p.m ET at the New York Stock Exchange. Shares can be bought or sold online using a brokerage account. For those working with a broker, orders can be placed with the broker, whose firm will execute the trade on your behalf.

When trading stock, you generally will incur a transaction cost of some sort. Full-service brokerage commissions generally are among the highest. Examples of full-service brokers include Merrill Lynch and Morgan Stanley. Online transaction costs generally are cheaper, with some firms offering a number of commission-free trades to induce new clients to move their business to the firm.

You will need to have an account with a custodian in order to trade stocks. There are many options available to you, ranging from traditional full-service brokerage firms to discount brokers like Charles Schwab, Fidelity and TD Ameritrade.

Pros and cons of stock investing

Some pros of stock investing include the following:

  • Investing in stocks can be a means of accumulating wealth. As the underlying company grows over time, the price of its stock has the potential grow along with its business.
  • Stocks can serve as a hedge against inflation.
  • Shareholders can benefit from preferential tax rates on long-term capital gains if they hold their shares for at least a year.
  • Stocks are traded throughout the day, and transactions generally are implemented almost instantaneously, especially on shares of widely traded stocks.
  • There are a variety of order types that can be used to set limits on the downward movement of your shares or to buy when a price trigger is met.

Here are some cons of stock investing:

  • Investing in stocks takes a level of research and knowledge that entails understanding the company’s underlying business and the factors that might influence the stock’s performance. This can take time and effort. Whether you are buying the shares to hold for a period of time or you plan to day trade, it’s important that you understand what you are doing.
  • Owning individual stocks can make it difficult to diversify your investment portfolio, especially for small investors. This might entail holding a concentrated position in just a few shares; if one or more of the stocks hits a rough patch, it can have an outsize impact on your wealth.

Options explained

Stock options offer the option holder the right to buy or sell shares of the underlying stock at a set price within a certain time frame. Beyond options that are traded on exchanges, employee stock options are issued by some companies as a form of compensation to their employees (or vendors and contractors in some cases).

Options can become quite valuable depending on whether the underlying stock moves in the direction the investor expects — up or down — as long as the move happens before the option expires.

Key option terms

A call option allows the option holder to purchase the stock at a set price within a set time.

A put option allows the buyer to sell shares of the stock at a set price within a set period of time.

The strike price is the price at which the option can be exercised.

The premium is the amount the buyer of the option pays for the option, and it represents the maximum profit the seller of the option can realize.

The option seller will be obligated to sell shares to the option holder if the call option is exercised or buy them in the case of the exercise of a put option. They can face a significant risk of loss.

For example, if a call option for 100 shares of a stock is exercised at the strike price of $10 per share, the option seller needs to furnish those 100 shares to the option holder. If they own the shares (a covered call), they would transfer the shares to the option buyer. If they don’t own the shares, they will need to go into the market, buy the 100 shares at the market price and furnish them to the option holder.

How options are traded

Options are traded on exchanges like the Chicago Board Options Exchange (CBOE). Options trade as contracts, with one contract covering 100 shares of the underlying stock or other security (exchange-traded funds, etc.).

The price you would pay for an option (or would receive if selling one) — the premium — has two components. The intrinsic value is the difference between the strike price and the market value of the underlying stock. The time component has to do with other factors, including the time until the option expires and the volatility of the stock. The price of the option contract will fluctuate based on these factors.

Three common options trading strategies

The long call is an options strategy in which the investor buys a call option with a strike price below their expectations for the stock’s price. They then can exercise the option and buy the stock at a below-market price if they are correct (and the option hasn’t expired).

In a covered call, the investor sells a call option at a strike price above the current price of the stock they own. If the stock remains below the strike price, they keep both their shares and the premium they earned when selling the option. If the stock surpasses the strike price, the investor will lose their shares but keep the option premium.

The long put is a bet on the decline of the price of the stock. The investor buys a put option. If the stock price falls to a level below the strike price, the investor may sell shares at the strike price. For example, if the strike price is $50 per share and the stock falls to $30 per share, the investor makes $20 per share, less the cost of the option. If the stock price is above the strike price, then the option will expire worthless and the investor is out the cost of the options.

Pros and cons of options trading

Here are some pros of options trading:

  • Options trading generally requires less of an investment than buying the shares of the underlying stock outright.
  • For option buyers, the maximum downside risk is the amount paid for the option. If it expires worthless, that is the extent of your loss.
  • Buying and selling options can provide relatively large gains for a relatively small investment.

Some cons of options trading include the following:

  • Like any other trading endeavor, successful option traders take the time to master what they are doing. That means it might not be the right path for “dabblers.”
  • Option sellers can lose a great deal of money if the stock moves drastically away from the strike price. You have virtually unlimited liability to provide shares for a call option buyer or to buy shares from a put option buyer.
  • Options come with a time limit. If the stock doesn’t move in a direction that benefits the option trader, the option can expire worthless.

How stocks and options are similar (and different)

Trading options has some similarities to trading stocks, including:

  • Success in both endeavors will be related to accurately picking the right stocks to focus on and the direction the stocks will move.
  • Choosing the right stocks and their underlying options to trade takes research and an understanding of the markets.

There are differences to be aware of, however:

  • Investing in stocks can be a long- or short-term endeavor. Options, by their nature, have a short-term focus.
  • Options are a “bet” on the movement of a stock and are short-term by nature.

While there are no hard-and-fast profiles of a typical stock or option investor, here are some common traits:

  • Stock investors typically will look at the fundamentals of the company as well as the relative price of the shares compared to their historical levels. Stock investors are interested in the price of the shares as well as the performance of the company. Stock investors may be short-term traders or long-term investors.
  • Options require less money than the shares of the underlying stock. Options traders often are those who want to profit from the price movement of a particular stock without having to own the stock itself.
  • It is common for investors to utilize both stocks and options. As an example, an investor who owns a stock might write options as way to make some additional money from the stock. Or they might purchase a put option to hedge against a drop in the stock’s price. There are many strategies investors can use that combine owning stocks and trading options to enhance their overall investing returns.

Bottom line

Investing in stocks and trading options are not mutually exclusive. In fact, options can be used as a method to complement your stock trading activities. Call options can be a way to speculate on the price of particular stock without having to commit the capital to buy the shares. Conversely, put options can be a good way to hedge against a drop in the price of a stock in which you currently hold shares.

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Investing

Here’s a Simple Guide to Understanding What Asset Allocation Is

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone and is not intended to be a source of investment advice. It may not have not been reviewed, commissioned or otherwise endorsed by any of our network partners or the Investment company.

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It’s important for investors to decide where and how to invest their money. Are stocks, bonds or perhaps cash the way to go? For many investors, a combination of these three basic asset classes may make sense.

A key component of investing is determining how to allocate your money among various types of investments — also known as asset allocation. Choosing the right asset allocation will balance out potential returns with potential risks.

What is asset allocation?

Asset allocation is based on the adage that you shouldn’t put all your eggs in one basket. In the case of investing, it’s about how you allocate your money between the three basic asset classes mentioned above. A proper asset allocation is one that balances an investor’s time horizon for their investment goals with their tolerance for risk (defined here as the risk of investment losses).

Within the three basic asset classes, there are a number of sub-asset classes to consider as well.

Stocks

Stocks are divided into sub-asset classes in a number of ways, but a key differentiator is market capitalization. Market cap is defined as the share price of a stock times the number of shares outstanding.

These are the basic types of stocks based on the market capitalization of individual stocks (or the average of stocks held in a mutual fund or ETF).

  • Large-cap stocks
  • Mid-cap stocks
  • Small-cap stocks

Large-cap stocks generally are larger companies, many of which are household names like Apple, Facebook, IBM, Johnson & Johnson and Microsoft.

Large-cap, mid-cap and small-cap stocks also can be divided into categories, such as growth and value. Growth stocks are companies that are growing faster than the average of a benchmark like the S&P 500, while value stocks may be undervalued compared to the average for the benchmark. Stocks classified as a blend are a mix of growth and value.

Stocks of domestic U.S. companies and companies headquartered outside the U.S. also are divided by market cap and investing style.

Bonds

Within bonds, there are a number of sub-asset classes. Some are based on the type of bond, such as government and corporate.

There are asset classes based on the maturity of bonds, including those with long-term, intermediate-term and short-term maturities. As a general rule, bonds with a longer time until maturity have a greater risk of price fluctuation over time. Bonds generally are less volatile than stocks.

Cash

Cash and cash-like investments generally are the least risky components of a portfolio and therefore generally offer the lowest returns.

Money market funds invest in a variety of short-term interest-bearing securities and are not insured by the Federal Deposit Insurance Corporation (FDIC). Money market accounts are government-insured, however.

Certificates of deposit (CDs) are interest-bearing accounts issued by banks. Your money is committed for a period (three months, a year, etc.), and you receive interest payments during that time while regaining access to your money at the end of the CD’s term. CDs are FDIC-insured.

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Why asset allocation is so critical in investing

Asset allocation helps investors choose a mix of investments in line with their risk tolerance, time horizon and financial goals. A classic 1986 study by Brinson, Hood and Beebower asserted that over 90% of a portfolio’s return was determined by its asset allocation. While this has been debated over the years by financial professionals, regardless of the actual percentage, asset allocation is an important factor in your investment performance.

Asset allocation and the concept of diversification go hand in hand. Diversification is a process that mixes a number of different investments within a portfolio. The main idea behind diversification is that different types of investments will do well under varying market and economic circumstances.

Correlation between investments describes the relationship between the movement across two investments. This is a statistical measurement. A correlation of 1 between two asset classes or investment vehicles means the movement between the two is perfectly correlated. A correlation of -1 means there is no correlation and the two asset classes move in the opposite direction.

For example, U.S. large-cap stocks and bonds have a correlation of -0.18 with each other. This means that factors influencing the performance of large-cap stocks and bonds have a very low correlation. Additionally, the correlation between these two asset classes is negative.

A well-diversified portfolio uses an asset allocation that contains some holdings that are not highly correlated with each. This can mean that some investments will do very well when the stock market does well, while other holdings might lag the market at times.

Overall, having some holdings that are not correlated can serve to mitigate a portfolio’s downside risk.

How to choose an asset allocation that’s right for you

An investor who’s just starting out might have a portfolio that includes just a few holdings. It doesn’t take a large number of holdings to achieve diversification.

If you’re a younger investor, your initial asset allocation might be more aggressive and heavily tilted toward stocks. You have a long time until retirement, and the short-term ups and downs of the stock market really don’t impact you.

Your asset allocation will evolve over time. Goals such as saving for your children’s education, purchasing a home, starting a business and saving for retirement will be factors in determining the right one for your portfolio. These and other goals will have different time frames and needs that could impact your asset allocation.

Additionally, your asset allocation will need to be maintained. Investments will perform differently over time. You will want to rebalance your portfolio back to your target allocation periodically to ensure it properly reflects your risk tolerance.

For those who are not comfortable doing their own asset allocation, there are some options.

Target-date funds are professionally managed portfolios that are geared toward a target retirement date. For example, a 2040 fund would have an asset allocation that is geared toward someone who is retiring in or near the year 2040.

There are a number of asset allocation calculators available online for you to try out. These calculators typically will use a questionnaire to break down your situation — including your age, when you will need to access the money and other factors. Then, they will take this information and determine an optimal one for you.

Robo-advisors can offer another way for investors to gain access to professional asset allocation advice. These services utilize algorithms (formulas) to do an asset allocation for you based upon your situation. They generally are registered as financial advisors and will manage your investments for you.

A financial advisor routinely devises an asset allocation for their clients as part of the process of investing their money. A good advisor will review your allocation periodically and adjust it as your situation changes.

Bottom line

Asset allocation is a crucial aspect of investing for investors of all ages. A well-constructed one can help you realize your investing goals. It’s all about balancing your potential return against a level of downside risk. The right allocation can help you achieve your investment goals and not take excessive risk while doing so.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.