ELI5: Interest Rates & The Stock Market

We saw a bit of red in the markets this week. The S&P 500 was down about 2%. Not a huge drop, but after seeing mostly green for a few months, even moderate losses are jarring. We got used to winning. The drop was largely attributed to a rise in interest rates. Similar to its relationship with bonds, interest rates and stocks tend to move in opposite directions.

When rates go up, stocks fall (and vice versa). This is broadly speaking of course. There's no exact way to explain stock movements, especially in the short term. Too many factors at play. Alas, the logic is generally sound.

When interest rates rise, money becomes more expensive. For businesses, the greater borrowing cost eats into their earnings. Reduced expected earnings trickles down to reduced stock prices.

For investors, when safe assets start yielding more, they become an attractive alternative. Low rates meant stocks were the only game in town. Investors would rather take a chance with stocks than earn nothing with bonds. When rates (and returns) rise however, investors might shift to bonds, putting a downward pressure on stocks.

If interest rates continue to rise, we might see more red, we might not. Markets are complex. Everyone is just making their best guess. I wouldn't think too much about the recent decline. If you have a diversified risk-appropriate portfolio, just hold on. Things tend to work out in the long run.

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