During its September meeting, the Federal Reserve issued a 50 basis point interest rate drop to combat inflation, which had risen rapidly in recent years. This is the first federal interest rate reduction since March 2020.
The decision to cut rates came as a surprise to many economists who had expected the Fed to maintain its hawkish stance on inflation. The move signals a shift in the central bank's strategy, as it attempts to balance the risks of persistent inflation against the potential for economic slowdown. Fed Chair Jerome Powell emphasized that the decision was data-driven, citing recent indicators that suggested inflationary pressures were easing faster than anticipated.
Investors sometimes react emotionally to major market volatility, which can endanger long-term growth, particularly in retirement accounts. What should they do instead? How will a lower Fed rate affect you? Financial planners weigh in.
The impact of the Fed's rate cut is likely to be far-reaching, affecting everything from mortgage rates to credit card interest and savings account yields. For consumers, this could mean more affordable borrowing costs, potentially stimulating spending and investment. However, savers may see a reduction in the interest earned on their deposits. As the financial landscape shifts, it's crucial for individuals to reassess their financial strategies and consider how these changes might affect their personal economic situations.
Don't panic sell amid short-term movements.
Ben Bakkum, a Betterment financial planner and senior investment strategist, cautions against panic selling in response to the Fed's rate cuts, since responding to market fluctuations might stifle long-term progress. What happens now that the Fed has cut rates is unpredictable, but there is no reason to panic.
"Ultimately, a lot of people miss out on returns they would have ended up with by being too reactive," Bakkum tells me. "They become alarmed by policy shifts and sell out of a diverse investment portfolio. Then they miss out on the subsequent advantages."
Avoid making significant adjustments to your long-term portfolio based on short-term market forecasts. He keeps going: "The majority of investment and retirement accounts are designed to withstand fluctuating market conditions and remain resilient during economic downturns."
It's worth noting that while the Fed's rate cut may cause short-term market volatility, historical data suggests that over the long term, markets tend to recover and continue their upward trajectory. Investors who maintain a steady course and resist the urge to make drastic changes based on temporary fluctuations often fare better in the long run. This underscores the importance of having a well-thought-out investment strategy that aligns with your long-term financial goals and risk tolerance.
Reduce risk exposure by diversifying.
Pam Krueger, founder and CEO of Wealthramp, underlined the importance of diversification and the need for a well-diversified portfolio to stay relatively untouched by the Fed's interest rate cuts. "Diversity wins every war. That means a varied mix of things so you're not reliant on just one thing, the economy."
Bakkum says the same thing. "You want to be diversified so that you can rely on the expectation of the consistent, annualized returns generally provided by the market," according to him. As long as you have a wide portfolio of stocks, bonds, and other securities, you should not face any significant losses, especially during Fed cutbacks.
Stocks may perform poorly now that the Fed has reduced interest rates, but they have the ability to rise as lower prices make borrowing more reasonable for consumers and businesses. Investing long-term allows you to rebound from the market's inevitable dips and valleys. Portfolio diversification is critical for risk management because the stock market cannot be predicted.
"You want to make sure you've got exposure to different areas of the market: mid-cap, small-cap, and international companies," says Jaime Eckels, financial planner and wealth management partner at Plante Moran Financial Advisors. "Decreasing rates should help smaller companies since they depend more on financing to spur growth and corporate profit."
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The Fed's cutbacks provide people the opportunity to reassess their portfolios and contemplate shifting investments. "Generally, lower interest rates benefit the economy as financing gets cheaper for individuals and businesses," Eckels explains. "Review your overall investment plan. Do not restructure depending on what the Fed or the market will do. Instead, return to your investment philosophy and determine why you're there."
Eckels invites investors to take a balanced view of how the market may change now that interest rates are expected to fall. "We have been pushing for a recession for years. We've been talking about recessions for a long time, yet we have yet to witness one. So trying to move the portfolio around, timing a recession or a Fed rate drop, is quite difficult. But this is a wonderful moment to review everything."
Ensure that your portfolio and existing investment portfolio are in line with your objectives and risk tolerance. You may wish to consult with a financial professional. "If you see yourself making an important life change that's going to impact your finances in the next year or so, this is the time to sit down and have a fresh pair of eyes," Krueger shares.
While reviewing your investment strategy, it's also important to consider the broader economic context. The Fed's rate cut is just one piece of a complex economic puzzle. Factors such as global trade tensions, technological advancements, and shifts in consumer behavior can all influence market performance. A comprehensive review should take these factors into account, ensuring that your investment strategy is not only responsive to interest rate changes but also resilient in the face of various economic scenarios.
Consider reallocating your cash to bonds.
Cash in high-yield savings accounts will be the most affected by interest rate reduction. Cash positions have been appealing in recent years, with annual percentage yields ranging from 4.5% to 5%. However, as interest rates decrease following the Fed rate cut, the appeal of these cash assets fades.
"It's easy to forget how much of an incredible wealth-generating engine the stock market is relative to something like a savings account or a money market mutual fund," Bakkum tells me. "If you're concerned about inflation eroding the purchasing power of your retirement assets, the stock market is an excellent long-term investment option. It is riskier, but you are compensated for the risk."
Bond prices grow when interest rates fall, offering another return component. "Bond ladders are useful if you have a distinct time horizon, want principal protection over that time period, and want to lock in an overall rate of return or yield," Bakkum explains.
He goes on: "However, I wouldn't recommend a bond ladder for retirement investors because the length of time you're in retirement is uncertain, so a more diversified exposure in the fixed-income space where you could still benefit from price returns."
As investors consider reallocating their assets in response to the Fed's rate cut, it's crucial to remember that each financial decision should be made within the context of a comprehensive financial plan. While bonds may become more attractive in a lower interest rate environment, they should be viewed as part of a balanced portfolio strategy rather than a standalone solution. Additionally, investors should be aware of the potential risks associated with bonds, such as interest rate risk and credit risk, and how these factors might affect their overall investment returns in the long term.
