Warren Buffett: How to Invest in Stocks During Rising Interest Rates

So last year, interest rates were at all-time lows, and the stock and real estate markets were skyrocketing. In September of 2021, yields, which is just a fancy way to say interest rates on 10-year government bonds, were hovering around 1.25. The tech stock-heavy NASDAQ was over 15,000, having more than doubled from its March 2020 lows, and the real estate market was probably the hottest it had ever been. Lines for open houses in some cities literally stretched outside the door and around the corner. The average price of a house in the United States was up nearly 20 percent over the past year, and some especially hot markets were up north of 30 to 40 percent.

But boy, do things change quickly in the world of investing. The biggest driver of this change has been skyrocketing inflation. The inflation rate here in the United States has crossed over eight percent, a level that has not been seen in 40 years. In order to get this inflation under control, the U.S. Federal Reserve has been forced to raise interest rates at an unprecedented clip. The yield on 10-year government bonds has tripled and is now hovering around four percent. We will get into this more later in the video, but this has sent shockwaves through the stock market and real estate market. The NASDAQ is down roughly 35 percent from its highs, with certain previous high-flying tech stocks down 50, 60, and even 70 percent from their highs. The previously red-hot real estate market has even cooled off, as the average mortgage rate has gone from three percent all the way to seven percent, with no signs of slowing down.

Okay, so with all this as background, it raises the question I want to answer in this video: How should we be investing during rising interest rates? Well, to answer this million dollar question, we will be turning to the investment icon Warren Buffett. Having bought his first stock at the ripe young age of 11, Buffett has been investing in the stock market for over 80 years. He has invested through times when interest rates were hovering around zero percent all the way to when interest rates were above 15. So it's safe to say he's lived through plenty of times when interest rates are rising, and let's just say he knows a thing or two about investing itself.

But first, we need to understand why interest rates even matter in the first place. Let's listen to Buffett's explanation, and make sure to like this video and subscribe to the channel if you aren't already, because all the support keeps me motivated to continue putting in the work to make these videos for you guys. You guys are great, and now here's Buffett.

"If you buy a 30-year government bond, it has a whole bunch of coupons attached. In the old days it does now, so electronic, but it has a whole bunch of coupons, and the coupon says three percent or whatever it may say. And you know that's what you're going to get between now and 30 years from now, and then they're going to give you the money back. What is the stock? Stock is the same sort of thing. It has a bunch of coupons; it's just they haven't printed the numbers on them yet, and it's your job as an investor to print those numbers on. If those numbers say 10 percent, and most American businesses earn over 10 percent on tangible equity, if they say 10, that bond is worth a hell of a lot more money than a bond that says three percent on it. But if that government bond goes to 10, it changes the value of this equity bond that in effect you're buying. You are buying, when you buy it, an interesting General Motors, or Berkshire Hathaway, or anything; you are buying something that over time is going to return cash to you — maybe a long time in terms of Berkshire, but it'll be bigger numbers. And those are the coupons, and it's up to you — your job as an investor — to decide what you think those coupons will be, because that's what you're buying, and you're buying the discounted value. And the higher the yardstick goes, and the yardstick is government bonds, the less attractive these other bonds look at that. And that's just fundamental economics."

So Buffett did a great job of explaining the theory behind how interest rates impact the value of a stock. However, I do want to add to his explanation with a tangible example to really demonstrate how changes in interest rates affect stock prices. As Buffett said, the true value of any stock is how much cash that stock is going to generate over its lifetime, discounted back to the present day using an interest rate.

Now, that explanation may sound super complicated, but trust me, the math behind it is actually super simple. So let's say we have a stock, and we want to calculate its intrinsic value. Based on our analysis, we think the stock can generate ten dollars a share in cash flow in year one and grow that at a rate of 15 percent per year for 10 years. So in this example, we will also be able to sell this stock for 150 at the end of year 10. This means that at the end of the 10th year we own the stock, we will have received 35 dollars and 18 cents in cash flow that stock generated, as well as the 150 we sold the stock for. So this means in year 10 we receive a total of 185 dollars and 18 cents.

Okay, so now that we have the future cash flows the stock will generate, we just have one last step to calculate the value of the stock. We have to discount those future cash flows using an interest rate, and this is where we really get to see how interest rates move stock prices. So let's just say we have an interest rate of six percent. Using the Net Present Value function in Excel, we get that our stock is worth two hundred and twenty-four dollars. Now, let's see what happens as we move the interest rate we use to discount the cash flows. During 2020 and 2021, interest rates plunged to all-time lows; the stock market skyrocketed. Let's see why.

Look what happens when we decrease our interest rate from six percent to four percent. The value of our stock shoots up all the way to 259. Notice how all the cash flows remain the same; the company isn't growing any faster or making any more money. The only difference is that we lower the interest rate from six to four percent. Let's even take it one step further and lower the interest rate all the way to one percent. That sends the value of our stock skyrocketing all the way to 326 dollars.

Interest rates are extremely powerful in impacting the value of stock prices. Notice how our stock increased nearly 50 percent of value just from the interest rates we used falling from six to one percent. However, interest rates have the opposite effect as they increase, and that impact can be just as dramatic, but this time in a bad way. Let's see what happens as we increase the interest rate in our example. Let's go from six to nine percent and see what happens. At nine percent, the value of the stock falls all the way to 182 dollars, and if the interest rate increases to 12, that value falls even more to 149. And just for good measure, let's see what happens if you crank the interest rate all the way up to 15. Raising the interest rate to 15 brings the value of the stock all the way down to 124 dollars.

This is what Buffett means when he says that interest rates are like gravity on stocks. As interest rates rise, they pull the value of stocks downward, and that brings us to the billion dollar question. Now that we know how big of an impact rising interest rates can have on stock prices, how should we be investing? Let's listen to what Buffett had to say when asked about how he factors interest rates or foreign currencies into his investment strategy.

"We always try to figure out what focus on what's knowable and what's important. Now, currency might be important, but we don't think it's knowable. Other things are unimportant, but knowable, but what really counts is what's knowable and important. What's knowable and important about Coca-Cola is the fact that more and more people are going to consume soft drinks around the world and have been doing so year after year after year. And the Coca-Cola is going to gain share, and that the product is extraordinarily inexpensive relative to the pleasure it brings to people. Coca-Cola in the 30s, when I was a kid, I bought, you know, four six for a quarter and sold them for a nickel each. That was a six-and-a-half-ounce bottle for a nickel a Coke, and you can buy a 12-ounce can now if you pick a supermarket sale for not much more than twice per ounce what it was selling for in the 30s. You won't find any products where that kind of a value proposition has developed over the years. So that's the kind of thing we focus on, and interest rates and foreign exchange rates, as important as they may be in the short term, really are not going to determine whether we get rich over time. The best time to buy stocks actually was in recent years: you know, has been when interest rates were sky-high and it looked like a very safe thing to do to put your money into treasury bills at Fort. Well, the actual prime rate got up to 21.5, but you could put out money at huge rates in the early 80s. And as attractive as that appeared, it was exactly the wrong thing to be doing. It was better to be buying equities at that time, because when interest rates changed, their values changed even much more so."

I've been able to identify three big takeaways from studying Buffett and how we should invest during this period of rising interest rates. The biggest takeaway is that, according to Buffett, rising interest rates shouldn't really impact how you go about investing. Buffett still buys great businesses that are run by great management teams and are selling at a discount to their intrinsic value. The only thing that really changes is the price Buffett expects to pay for those stocks. This gets back to the earlier example where we looked at how different interest rates impact a stock's value. Remember Buffett's quote: Interest rates act like gravity on stocks. As interest rates rise or fall, you have to adjust what you consider to be a fair price for any given stock accordingly.

The second piece of advice is that you have to be okay with short-term volatility in stock prices. Volatility is really just a fancy word of saying how much the price of a stock moves around from day to day. During periods of increasing uncertainty about interest rates and the broader economy, those movements in stock prices become even more dramatic. Just look at a chart of the S&P 500 stock market index over the past year. Look how much the stock market has bounced around. I agree with Buffett that it is impossible to predict the day-to-day movements in stock prices. A stock you own may be down three percent tomorrow for a seemingly no good reason. Stocks can fall 10, 20, or even 30 for reasons that don't really make sense to someone who's focusing on the fundamentals of the business. One tangible piece of advice on how to be okay with short-term volatility is to only check your stock portfolio once a week or once every two weeks. This helps you ignore some of the short-term volatility in stock prices.

And this leads us into lesson number three, and boy, it's an important one: Invest for the long term. Buffett said that periods of high interest rates can be some of the best times to buy stocks. In the early 1980s, interest rates were at the highest levels in the history of the United States. Stocks were getting pummeled as a result. People would have said that you would have been crazy to buy stocks at this period of time. However, this turned out to be one of the best periods in the last 100 years to buy stocks. One thousand dollars invested in the S&P 500 in the year 1980 would have turned into over a hundred thousand dollars at the beginning of this year. This just shows the power of investing for the long term.

So there you have it. Make sure to like this video and subscribe to the Investor Center, because it's my goal to make you a better investor by studying the world's greatest investors. Talk to you again soon.