Why do stocks suffer when interest rates rise?

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In this episode, Adam Nash explains why stocks suffer when interest rates rise. Since 2017, Adam Nash has taught “Personal Finance for Engineers” at Stanford. He's covered topics from compensation, investing, to real estate. He’s the Former President and CEO of Wealthfront, Former Vice President of Product & Growth of Dropbox, and on the Board of Directors at Acorns. He’s currently the CEO and co-founder of Daffy, a not-for-profit community built around a new, modern platform for giving.

Interest rates have been going up all year in 2022, and the stock market has suffered.

And a lot of people have the question, why do stocks go down when interest rates go up? And the answer is that actually higher rates are a triple whammy against stock prices.

First, stocks are an investment. You believe that in the future, the stock is going to be worth a lot more than today. But investors have a choice where to put their money. When bonds are only paying 1%, they're not as attractive as stocks, which might yield 5%, 6%, or 7% long term. But when bonds start yielding 4% or 5%, that stock has to be really amazing to be worth the investment.

Another way to look at it is if you're thinking that a stock is going to be worth a value in the future, having a higher bar to clear in terms of an investment rate means that you're willing to pay less for it today. The second reason that higher rates hurt stocks is that they hurt the costs of the business. A lot of companies, the cost of doing business is partially based on interest rates. If you have to build a new factory, you have to get the real estate for a factory, you have to get loans to pay for the factory, and higher rates mean your costs go up. If your costs go up, that means your profits go down, and stocks are largely valued based on profits.

Third, there's a real problem with higher rates and what they mean about the economy overall.

When rates go up, it's usually a sign that the economy is going to slow down. Slower economy means less purchasing, less purchasing means less revenue, and less revenue eventually means less profits for those businesses. So for all three of those reasons, when rates go up, you tend to see a lot of pressure on stock valuations until rates start going down and people see brighter days ahead.

Please note that the information contained on this page is for educational purposes only and should not be considered tax advice. Any calculations are intended to be illustrative and do not reflect all of the potential complexities of individual tax returns. To assess your specific tax situation, please consult with a tax professional.

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