If you really want to beat the stock market, you need to study stocks in terms of P/E, RoE, EPS, profit ratio and so on. No investor would be able to beat stock market on a consistent basis without proper understanding of interest rates, inflation and bonds. In fact your success in the stock market is firmly tied to your sound understanding of these concepts.
Now what is interest rate?
Most probably you’ve heard about this term before. You can’t deny the fact that the interest rate plays a vital role in the global economy. It’s always going up and down all the time. Interest rate is the amount charged, expressed in percentage term of principal by a lender to a borrower for the use of assets. Assets may be cash, consumer goods, vehicles, houses etc.
It is the cost of debt for the borrower. Today’s Interest rates use to apply typically on annual basis as cost of debt or price of money for borrowing money to purchase homes, fund projects, start businesses etc. The money to be repaid on installment basis in addition to principal amount for using borrowed money is usually the rate of return for the lender.
Why are interest rates so critical in stock investing?
When interest rates rise, business becomes more difficult and vulnerable to move forward and vice versa. In lower interest rate regime, the value of existing investment property increases because more and more buyers can now borrow money, that in turn increases demand. A simple calculation can disclose everything to you.
Let’s say for a 30 years mortgage loan, one bank offers lending rates today @ 6% & another bank offers @4% for a $100,000 house loan. In this case, your annual interest payment would be $6000 and $4000 respectively. So what would you do in this scenario? Obviously you would go for 4% interest rate. The lower interest rate makes the house more affordable to more people increasing demand and the asking price.
The difference between interest rates creates a disparity between price and value. This is where an investor makes money in the stock market. Best interest rates is often indicate a ‘government bond interest rate’ that determined by Federal Reserve in almost all modern countries. In the USA, it’s FED. As an investor, the important thing you need to know that the FED purposely adjusts the interest rates to improve the slow the growth of the economy.
In recession time, the governments want to spend more money by lowering the price of money or interest rates. When more money is spent, it will increase consumption that in turn leads to more employment generation and wealth creation. And when interest rates are low, companies are able to borrow more for less. This makes new investments more attractive, which again leads to more employment and more wealth. When things are expensive, we tend to buy less.
As a stock investor, it is extremely important to keep an eye on the interest rates. When money is cheap, stocks are typically cheap too. This is the prime time to accumulate as many shares. In good times, the government tries to avoid bubble in the market. You really do not want a bubble because it creates instability in the economy. As a successful stock investor, bubbles and interest rate swings present enormous opportunities. If you want to master the stock market, start with a firm understanding of interest rates. It’s truly the foundation to the entire economic cycle and value of everything on the planet. Remember, there’s a big difference between price and value, and interests are key ingredient to their disparity. Determining this difference will be the ultimate key to your success.