Interest Rates And The Stock Market: Explain It Like I’m 5

Knowing Interest Rates for investing is key. we will break down the relationship in this post

“If you can't explain it to a six year old, you don't understand it yourself.”

-Albert Einstein

When interest rates go up, this puts pressure on stock prices to go down, and visa versa. Interest also tend to affect some types of stocks more than others (i.e. when interest rates go up, some types of stocks will go down more than others, and visa versa).

Now let’s talk about why this is with a (we hope) simple analogy.

The Simple Explanation

Let’s say you have two amazing daughters, one is five and the other is 17. You and your husband each drive them to soccer practice every day in the afternoons after school (in different locations).

Your 5 year old recently started but your think she could be really talented one day (she is already showing some serious skills). Her older sister is already established and close to potentially getting that college scholarship.

In this scenario, think of each of them (just their soccer ability, of course) as two stocks you have invested in for the future in the hopes that they may earn a college scholarship one day.

Regarding their soccer potential, your eldest daughter would be your more “mature stock” as you have a better idea of her ability (since she is older and already close to a scholarship). Your 5 year old would be your “growth stock” as her future potential is much less certain at this point (but as noted she is showing some serious early skills and potential).

Now lets say that gas prices suddenly spike higher. In this scenario, you can think of gas prices as interest rates.

If gas prices suddenly spike higher, it will put downward pressure on your family’s ability to drive both of them to practice everyday after school as it will be much more expensive. The reverse is also true if gas prices were to move a lot lower quickly.

That is exactly how interest rates work in their relationship to stocks.

Now lets take it a step further and talk about why some stocks are typically affected more than other stocks on this move higher in rates.

Tech stocks (a.k.a growth stocks) typically have a lot of future potential (think artificial intelligence), but a much less certain future picture today. More mature stocks (think Coca Cola), have a much more certain picture today but don’t have the growth profile that a tech stock does.

To illustrate this point further on future potential, we can bet that in 10 years you are more certain that Coca Cola will still be selling soda vs. your certainty level of what an artificial intelligence company will be doing in 10 years (???). When it comes to growth, we would also bet you might agree that the artificial intelligence industry will likely be growing faster and developed faster over the next 10 years than the soda industry.

As we noted above, when it comes to your family, your five year old’s soccer ability is your tech stock and your 17 year old’s ability is your Coca Cola stock as these same characteristics would apply to their respective soccer abilities.

When gas prices go a lot higher higher, since your five year old’s soccer future is much less certain (your 17 year old is much closer to getting that college scholarship), we would bet that if you are forced to choose, you would continue to “invest” in your 17 year old by driving her to practice and maybe let your 5 year old wait until next year.

And that is exactly how interest rates work on different types of stocks. When they go much higher, this creates uncertainty around the future leading more people to typically stick with what they know now and are more confident in right now (i.e. Coca Cola or your 17 year old’s soccer ability) over what has a lot of potential for the future (i.e. artificial intelligence or your 5 year old’s soccer ability).

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