Why is understanding interest rate risk important for investors?

Understanding interest rate risk is crucial for investors because fluctuations in interest rates can significantly affect the value of their investments, especially fixed-income securities such as bonds. When interest rates rise, the prices of existing bonds tend to fall, as new bonds are issued at higher rates, making the older ones less attractive by comparison. This inverse relationship means that if an investor holds onto a bond until it matures, they might not experience any loss, but if they try to sell it before maturity, they could face a reduced price due to higher prevailing rates. Additionally, this understanding helps investors to adjust their investment strategies accordingly, potentially selling off assets or reallocating funds to mitigate losses as interest rates change. Therefore, recognizing interest rate risk informs decisions that can enhance portfolio performance and protect against adverse market movements.