Should Interest Rate Changes Affect Your Decision To Invest?
It can be tempting to adjust your investing strategy based on the news, including news about interest rates—and there’s been plenty of that lately, as many people speculate about if and when the Federal Reserve will cut the target range for the federal funds rate. In a previous blog post, we wrote about how investing based on interest rate levels is unlikely to work out in your favor. But you might wonder whether investing based on movement in interest rates is a good idea. In other words, if you hold more cash when interest rates are rising and then invest more when they start falling, can you improve your returns?
While history can’t predict the future, looking at historical data is one of the best tools we have to try and answer such questions. That’s what we’ll do in this post.
What happens when you change your investing strategy based on interest rates?
To try to answer this question, let’s start by assuming we have $100 to invest at the end of every month. Each month, we’ll decide whether to invest that $100 in US equities or keep it in cash. We’ll use data from Kenneth French’s website as the source for both US equity market returns and the one-month Treasury bill rate (which we use to represent the risk-free rate, or the rate you get for holding cash). We’ll look at the data back to 1926, and try out three different strategies:
- Strategy 1: US equities only. Each month, we invest our monthly deposit directly in the US equity market regardless of interest rates.
- Strategy 2: Interest-rate timing. We use interest rates to decide whether or not to invest each month. In a rising-rate environment, we keep our deposits in cash and earn interest. As soon as the interest rates start dropping, we invest all of our accumulated cash and continue directly investing new deposits into US equities. It’s worth noting that we assume a perfect knowledge of upcoming interest rate movements so we are able to identify interest rate peaks/troughs, which wouldn’t be the case in the real world.
- Strategy 3: Cash only. We don’t invest. Each month, we keep our deposit in cash and earn interest.
To identify periods of rising and falling interest rates, we identified the peaks and troughs as shown in the plot below.
Interest rates 1926-2023
To compare the performance of the three strategies, we can compare each one’s annualized time-weighted return (ATWR) and internal rate of return (IRR). (As we’ve explained in a previous blog post, the difference between the two is that IRR takes into account the timing of deposits and withdrawals, while ATWR does not.)
Equity only vs. interest-rate timing vs cash only: 1926-2023
Equity only vs. interest-rate timing vs. cash only: 1926-2023
Source: Kenneth R. French data library
Not taking into account the timing of our deposits and withdrawals, regularly investing in US equities outperformed both interest-rate-based timing and regular deposits into cash. However, because the interest-rate-based strategy tries to time deposits in order to improve returns, it is more interesting to look at IRR. In this case, equities-only strategy still outperforms both other strategies, and is ahead of the interest-rate-based strategy by 0.3%.
This might seem like an insignificant difference, but consider how 0.3% compounds over the long term. Imagine we start off with a $1,000 initial deposit and a monthly $100 deposit over a 30-year horizon. The equities-only approach would result in a final portfolio balance of $285,904.50 compared to $267,430.90 when trying to time interest rates—earning you an additional $18,473.60.
History tells us that US equities outperform cash both when rates are rising and when they are falling. To illustrate this, let’s look at the average overall performance of the US equity market versus cash when rates are increasing and decreasing. The figures below are the average annualized returns during periods of increasing and decreasing interest rates.
Average annual US equity market returns vs. average annual cash returns: 1926-2023
Average annual US equity market returns vs. average annual cash returns: 1926-2023
It is clear that regardless of interest rates, the US equity market has historically considerably outperformed cash, with its return being at least two times as high.
The takeaway: Keep investing regardless of what interest rates are doing
Your investment habits should match your financial goals, and shouldn’t change based on the movement or levels of interest rates. Here’s how we suggest you approach the decision about what to keep in cash versus investments:
- Keep short-term savings in a high-yield cash account. The Wealthfront Cash Account offers a high 5.00%% APY, one of the highest on the market, and up to $8 million of FDIC insurance through our partner banks.
- Consider bond ETFs for your medium-term savings. If you anticipate needing to use your savings in one to three years, then consider bond ETFs. Wealthfront’s Automated Bond Portfolio provides the benefit of high-yield bonds without sacrificing liquidity. It is constructed with a diversified set of bond ETFs to provide higher yields than a Cash Account or Treasury bills, but involves less risk than equities or corporate bonds. We designed this to be perfect for saving for goals such as a down payment on a house.
- Save for the long-term in a diversified portfolio of low-cost index funds. For any long-term savings you won’t need in the next three to five years, we suggest investing in a diversified portfolio of low-cost index funds. Wealthfront’s Automated Investing Account is a great option for this: It’s personalized to your risk tolerance, has a low 0.25% annual advisory fee, and is constructed using Nobel Prize-winning research to maximize your after-tax returns while minimizing unnecessary risk.
We know it’s tempting to change your long-term investment strategy based on short-term market and interest rate movements. As this post demonstrates, history tells us that probably isn’t a good idea. We hope this analysis helps you feel more confident about sticking to your investing plans regardless of whether interest rates are increasing or decreasing.