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Is Your Portfolio Properly Seasoned?

Jan 11, 2008
The effect interest rates have on the performance of our economy cannot be overstated. Understanding how interest rates affect the business cycle will help you know how to structure your portfolio to achieve growth while minimizing risk. Read on to learn more.

Would you wear a winter parka on a Florida beach in the middle of summer? Of course not. I doubt any of us would wear a bikini to go ice fishing in the middle of a Minnesota winter. I know I wouldn't!

Clothes are a tool that is used to help regulate our body temperature. They protect us from the cold or keep us from over-heating. Their proper use determines our comfort from one season to the next. We don't want our body temperature to wildly fluctuate up and down.

It's the same when it comes to investing. Unfortunately, many don't understand the changing of economic seasons and therefore fail to adjust the clothing used in their portfolio. As many saw in 1997-2000 and 2000-2002, the investment clothes that work in one season are close to useless in another.

There are economic business cycles. There are seasons when the economy is expanding, other's when it is contracting. There are also times (called peaks and troughs) that are like spring and fall, times of transition from one major cycle to the other.

Interest rates are one key in determining where we are in that cycle. The Federal Reserve uses the rate it charges on over night loans to banks (the Fed Funds rate) as an accelerator or brake on the economy.

It may seem strange that small changes in the over night rate banks pay could have an impact on the overall economy. Banks lend more money then they receive in deposits. That "extra" money comes from inter-bank loans and is referred to as the Fed Funds Market. It stands to reason that if a bank pays more on what it borrows, it will have to earn more on what it lends.

The Federal Reserve controls the Fed Funds rate by putting money into the inter-bank loan market or by taking it out. Just as supply and demand causes the price of a stock to go up or down, so is with the interest rate charged in the Fed Funds market. By putting money in or taking money out the Federal Reserve is able to artificially control the supply demand balance.

Interest rates affect every area of our economy. If you have to pay a higher interest rate on a mortgage your monthly payment is going to be higher. Since you can only afford to spend so much a month on that payment, the interest rate affects the how much home you can afford.

Likewise, most businesses borrow money to fund expansion, cover inventory and to smooth out cash-flow. Just like the homeowner, they have a limited amount they can afford in payments each month. The amount they borrow affects whether they can build bigger plants, buy more computers or hire additional employees.

Different industries do well in different parts of the economic cycle. The construction industry will perform best during periods of low interest rates because low interest rates are designed to spur growth. When people and businesses can borrow at low rates they will build new homes, skyscrapers and factories.

Similarly, we each tend to buy the same amount of toothpaste and toilet paper regardless of where interest rates are. The companies that make those essentials aren't going to see the big change in demand for their product that a construction company might.

Equity investments can be categorized as cyclical or non-cyclical based on how they are affected by changes in the economic cycle. The proportion of each in a portfolio will greatly affect the overall volatility. I recommend having a portfolio of high-quality non-cyclical companies. You can then introduce cyclical companies as the seasons change to add additional growth. Make sure you adjust the cyclicals as the seasons change.

Economic cycles don't just affect stocks. They determine whether it is a good time to own bonds, and what type of bonds to own, as well. The last several years, interest rates have been at historic lows. You don't want to lock in low rates for 30 years. When interest rates are above the historic norms, that's when you want to stretch out your maturities.

Think of your investment portfolio as a living, breathing entity. Recognize that the investments used in it will determine your comfort level as the economic seasons change. Doing so properly will allow you to increase your return while reducing your risk. Take advantage of economic cycles. Don't let them take advantage of you.
About the Author
Nationally-syndicated financial columnist and Certified Financial Planner(R) Jeffrey Voudrie provides personal, in-depth money management services and advice to select private clients throughout the USA. He'll answer your financial question - FREE at

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