Investing

The basic math concept that can help you understand the effect of rising rates on your investments

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Key Points
  • The Federal Reserve is expected to embark on a series of interest rate hikes with a 0.25 percentage-point boost next week.
  • Remember: Percent change describes the difference between two values. Percentage points describes the difference between two percentages.
  • Percentage-point hikes in interest rates generally correspond to losses in bond portfolios.

If you're hoping to have a good understanding how markets and the investments in your portfolio move, you'll have to remember your lessons about percentages from junior high.

Percent change is a calculation that measures the difference between two values. If you buy stock at $10 and it rises to $15 per share, its value has increased by 50%.

But what if you're looking to describe the difference between two percentages? For that, the clearest way to express change is through percentage points.

It's a convention you're likely to see in financial headlines soon. The Federal Reserve is expected to hike interest rates by 0.25 percentage points (also known as 25 basis points, investor jargon for hundredths of a percentage point) next week — the first of several boosts to interest rates economists project to come in 2022.

Depending on your holdings, those percentage-point increases in rates could lead to movements in the value of your investments. Here's why, and how knowing some basic math can help you prepare for rising rates.

The difference between percent and percentage points in action

If you see headlines saying that interest rates are rising by 0.25%, rather than percentage points, they're technically mistaken. Delving into some other common uses for percentage points shows why.

Over the past year through March 4, the S&P 500 returned about 10.6%. The Nasdaq Composite returned about 2.6%. The S&P, therefore, outperformed the Nasdaq by 8 percentage points.

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Why not use percent change in this case? Because expressing things in terms of percent change can quickly get misleading. Instead of saying the S&P's 10.6% return beats the Nasdaq's by 8 percentage points, you could say with equal accuracy, and more clarity, that it was 307% better.

This principle doesn't just apply to big numbers. Say one bank account pays 1% in interest and another pays 1.5%. You have a much better idea of how they compare if you're told one pays half a percentage point more, rather than that one offers a rate that's 50% higher.

A scenario that uses both: yields and interest rates

Back to the rate hikes. When interest rates rise, because bond prices and interest rates move in opposite directions, the value of any bond mutual funds or ETFs you may own will drop. (You may not own any bond funds outright, but if you own a target-date fund, you might be invested in bond funds.) The question is, by how much?

The answer lies in understanding both of percent change and percentage points. Can you hear your math teacher applauding in the distance?

Any bond fund you own has an average duration — the measure of bonds' sensitivity to movements in interest rates. The duration of the Bloomberg Barclays U.S. Aggregate Bond index, a proxy for the broad U.S. bond market, is currently 6.64. That means a fund tracking that index would decline in value by 6.64% if interest rates were to rise by 1 percentage point.

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There's no clear consensus on just how much interest rates will go up, but analysts at Morgan Stanley, for instance, currently expect the Fed to hike rates six times for a total of 1.5 percentage points this year. That would take a big bite out of the value of bond funds with long durations.

If the bond funds in your portfolio meet that description, some experts say you may want to consider moving into funds that hold bonds that will come to maturity sooner, as those will come with less sensitivity to rising rates.

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