Investing: ”How do interest rates affect investment returns?”
The Relationship Between Ms. Market, the Currency, and Investment Grade Assets:
(Ms. Market is my spin on Warren Buffett's famous Mr. Market references in his annual letters in the 80s and 90s)
Interest rates reflect Ms. Market's (the collective mind of all participants) interest in a currency.
For the sake of simplicity, let’s define a currency as the most accepted form of money in an economy for buying and selling goods and services.
For now, the currency for our economy and the global economy is the dollar so for the most part when you are hearing about interest rates in business and financial news they are talking about the rate of interest paid for borrowing dollars in the short term.
Why would anyone need to borrow money in the short term? There are tons of reasons, but the most important reason in the context of a large economy is to cover short term expenses for businesses and governments that can’t be covered by the cash they have in the bank. Because so much business is done through credit (buy now and pay later), it is super common for businesses to need to borrow money to run operations while they are waiting for payment on products they’ve already sold or services they have already performed.
I like to picture the relationship between Ms. Market’s interest in dollars vs her interest in investment grade assets as a seesaw with dollars on one end and investment grade assets on the other. Higher than expected short interest rate, reflects Ms. Market’s higher interest in owning dollars and her lower interest in owning investment grade assets (stocks, real estate, cryptocurrencies, etc). Lower than expected short term interest rates reflect her lower interest in dollars and her higher interest in investment grade assets.
The Consequences of Manipulating Ms. Market
The Federal Reserve (The Fed) is the banking organization for the US Government. It’s not a government organization, it’s literally their banker made of a conglomerate of banks with twelve member banks across the country each with a representative. They have lots of responsibilities, but their main responsibility is to make sure the US Government can borrow dollars at favorable rates to pay its bills.
For now, let’s not worry about how the Fed manipulates short term interest rates thereby affecting the mood of Ms. Market because that would take a while to explain and you might find it extremely boring. Just know that they have methods and means of manipulating the price of money (interest rates) in the short term.
Anytime man messes with natural laws of balance that operate the universe it comes at a cost.
Here’s how this translates to the relationship between Ms. Market (the collective mind of market participants), dollars, and investment grade assets in the short to mid term.
The Fed does its thing to manipulate short term interest rates. This eventually ends up causing the cost of living to rise faster than what Ms. Market was earning on the money she had saved in savings accounts (they pay close to the short term interest rate). Once Ms. Market realizes she’s being taken advantage of, she becomes upset, loses faith in the dollar, and moves away from the dollar which by default moves her towards investment grade assets that have been growing at a higher rate than the cost of living. The investment grade assets promising the most potential return tend to get the most of her attention regardless of their credibility. Ms. Market is now upset emotionally about basically being stolen from. Her thinking at this point is, “Well, I don’t know who to trust so I might as well go after the biggest bag.”
The momentum of Ms. Market’s anger eventually pushes her to become overstimulated and her attention gets focused way too far out into the future beyond her understanding which creates bubble manias (i.e., 2000s dot.com crash and crypto bubble in 2017). This creates a shortage of money in dollars in the economy which provides a cushion for the financial system.
That shortage of dollars needed for the system’s cushion leads to violent mood change in the opposite direction when Ms. Market realizes most of the investment grade assets promising the biggest bags were all talk and won’t have the dollars to give her back the money she invested. Now she moves into panic mode and she begins focusing all of her attention (invests her money) in dollars and that sucks lots of money out of the economy which slows down business and depresses asset prices (The Financial Crisis of 2008). This creates a shortage of money in the economy.
How to Attract the Heart of Ms. Market and Maintain Her Trust Over the Long-Term
Over the long term however, Ms. Market is attracted to Balance as dollars go into investment grade assets at a steady pace to finance the growth of the new ideas that create the ongoing evolution of mankind. No different than the individual maturing process we all go through as we have new experiences. “As within, so without.”
How does she find Balance? That can be found through what we finance nerds call price discovery and psychologists call the maturity process that happens through life experience.
The cool part about being an individual participant in the market (an investor) is we get rewarded when we mature in our understanding faster than the market. The Patient Optimist wins the heart of Ms. Market over the long term as it shows her it's exciting and reliable, fun and grounded, peaceful and about that life…Balance.
Here’s a very grounded way to find balance in your investing approach:
Phillip Washington, Jr. is a registered investment adviser and Host of the Wealth Building Made Simple Podcast. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.
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