Cash and Bonds are Okay Investments

Hiking in the Pacific Northwest can be an interesting experience. During the winter, many hikes start at a lower elevation with no snow, and midway through the hike, there are inches of snow, and then feet of snow. If you start from the bottom and judge the conditions solely based on what you see, you may reach the conclusion that you need nothing more than a good pair of shoes and a jacket. 

The problem is that you will be woefully unprepared for a winter hike. 

There is a variety of gear you need to bring with you, even if you never use it. You’ll need:

  • Navigation, such as a map, compass, or GPS device
  • Light source, such as a headlamp or flashlight
  • Sunglasses and sunscreen
  • First aid kit 
  • Knife
  • Heating source, such as a lighter or matches
  • Shelter, such as an emergency bivvy
  • Extra Food
  • Water, more than you anticipate using
  • Extra clothing, with lots of layers to adjust to the temperature 
  • Microspikes or snowshoes

If you are really adventuring out, you may need a portable shovel, avalanche beacon, ice ax, duct tape, toilet paper, gaiters, or other items. 

When passing experienced hikers in the winter, you often see them carrying a big pack stuffed with these items. They are prepared for any situation. Their hike may go as planned or they may become stranded for the night or need to aid another hiker. 

Occasionally, you see less experienced hikers with minimal gear and tennis shoes. Thankfully, I see less of this in winter, but I see it frequently in the summer. 

For most winter hikes, the hike will go as planned. You’ll start your route at the time you expect, have an idea of what conditions you’ll experience because you will have already researched recent trail reports, and use only a fraction of your gear before returning to your car. 

Most of the gear sits in the pack untouched. 

Other people may look at the pack and say you brought too much, but they are wrong. I rarely use my extra clothing, headlamp, or emergency blanket, but the few times I’ve needed the extra gear, I’ve really needed it.

Hiking gear is like cash and bonds

I remember one hike with a friend where we expected rain, but ended up in a downpour, and there was so little forest cover that the rain soaked through every layer we wore. It went through our rainproof jackets, through our fleece, through our shirts, and down to the skin. It was the same for our rainpants and underwear. By the time we got back to the car, I was ecstatic to have a full set of dry clothes waiting for me. 

Do you know how many times I’ve used my extra clothing for day hikes? One – just that one time, but I still bring it every time. 

I’ve had a few close calls with hiking near dark where I may have needed the headlamp, but I haven’t used it yet. I still bring it and check that the batteries are working because I never know when an emergency may occur. 

The point is that certain items feel like excess weight. It feels wasteful to bring them, but using them once can literally save your life, which makes it worthwhile to bring them every time. Plus, they give confidence, when out in the wilderness, to go on more adventures, hike a little farther, and have new experiences. 

How Cash and Bonds Allow for Compounding

In the investment world, there are many investments that feel like excess weight. For example, many people do not see the point of cash or bonds. They want to be as aggressive as possible and invest in 100% stocks. For some people, that may be okay, but for most, it is a setup for a cruel lesson. 

Charlie Munger, a famous investor, once said, “The first rule of compounding is to never interrupt it unnecessarily.” 

To do that, you need a strategy you can stick with long-term – something that can go uninterrupted for decades. Most people feel 100% stocks are a good strategy until they hit their first significant decline and their portfolio drops in value 30%+ and takes more than a year to recover. 

Morgan Housel, one of my favorite writers, was on Masters in Business with Barry Ritholtz and said the following: 

Cash and bonds is often associated with conservatism. Not wanting to take a lot of risk. Not wanting to be subject to a lot of risk, and I just don’t think that is the case. What they do, what cash and bonds do is they allow the stocks you do own to be left untouched, uninterrupted, so they can compound over time. The great quote from Charlie Munger is ‘The first rule of compounding is to never interrupt it unnecessarily.’ And when you think about it in those terms, then you realize the cash and bonds you do own, who cares if you are earning no return or a negative return during these times if once per decade if that cash and bonds can prevent you from being forced to sell stocks at an inopportune time? They are going to earn all their return and then some.

– Morgan Housel

I love what Morgan Housel said because he cares about the times when most people throw in the towel and sell. Those are the times that make or break investor returns. It’s not the time when all markets are going up 10% per year. Those are easy times when it looks like nobody can do any wrong.

It’s the behavior when we hit recessions, global pandemics, and financial meltdowns that define an investor. For example, if you sold during the bottom of a stock market decline – even just once – you will lower your long-term return. 

It’s like hiking. You may never get stranded in the wilderness and need your emergency bivvy to crawl into to avoid freezing to death, but without it, you may never walk out of the forest alive. It pays for itself once with your life. 

The extra times you carried it and never used it – who cares? 

The same can be said for cash or bonds. 

Take this example. You first invest in 100% stocks and earn 10% per year for 10 years, but then you sell after a 30% decline. Then, you are hesitant to get back into the market for years because you were too aggressively invested to begin with. In this example, you likely will do worse than someone who invests in 80% stocks and 20% bonds, avoids selling at the bottom, and continues investing.

Were the bonds a drag on returns compared to stocks? Depending on the time period, it is likely. But then again, who cares? 

If they allow you to stay the course, they pay for themselves and then some. 

For example, if you invested $5,000 per year and earned 7% per year for 40 years, you would have over $1M by the end. Instead, if you panicked every 10 years, sold your investments, and earned 0% in the 10th, 20th, 30th, and 40th year, you would only have about $810k. 

Selling out only four times out of forty hurt you to the tune of about $190k. 

Although I’ve assumed a very simple example, the real-world results can be even more pronounced. Some people sell and don’t get back in for years, sometimes decades. You can imagine what that would do to your total wealth. 

Or, raise the stakes and assume you contribute $19,500 every year. In the same example from before, the person who earned 0% returns only four times had about $750k less at the end of forty years. 

As I said earlier, even missing just one year of good returns can drastically change your total wealth over time. 

Common Arguments for Why Cash and Bonds are Bad Investments

Over the course of your life, you’ll likely hear a few different arguments about why cash and bonds are bad investments. I’ll go into a few of them, how some are valid but need to be taken in context, and how to think about it in your own situation. 

Here are the main arguments:

  1. Cash is low yielding and will lose to inflation
  2. Stocks always have higher returns than bonds over longer periods of time
  3. Interest rates will only go up, which will cause bond prices to fall

Cash is Low Yielding and Will Lose to Inflation

Yes, cash is low-yielding. Most high-yield online savings accounts are offering 0.5% APY as of this writing in April 2021. Inflation has been under 2% for most of the past decade. 

If inflation is around 2% and you are earning 0.5%, the argument holds up. You are losing about 1.5% per year with cash. 

However, it does not matter if you are holding reasonable levels of cash. If you are holding 50% of your portfolio in cash and don’t have enough cash to last your entire life, inflation likely will be a problem for you. 

If you are like most people and have 3-12 months of living expenses in cash, then your cash can be a great investment. 

The global pandemic and markets falling about 30% in three weeks taught people an important lesson about holding cash. Those with many months of living expenses in cash were likely far less concerned by the decline than those with very few months. 

Again, cash allows your stocks to compound uninterrupted. Losing 1.5% on $20k in cash pales in comparison to interrupting the compounding of tens or hundreds of thousands of dollars in stocks. 

For example, your $20,000 may only be worth $19,700 the following year because inflation ate away at the purchasing power, but if that meant you could earn 10% on $50,000 ($5,000), that means you came out ahead $4,700. Repeat over decades and that is a sizeable amount of money! 

Financial returns aside, cash can provide a high peace of mind return. It’s not going to fluctuate 3% in a day or 30% in a year. I once heard the phrase, “Stocks allow you to eat. Cash and bonds allow you to sleep.” It hits the point that stocks will likely be your driver of growth, but cash and bonds help balance out your investing experience for peace of mind. 

Stocks Always Have Higher Returns Than Bonds Over Longer Periods of Time

This one is flat out wrong. There have been many long periods of time where bonds did better. 

For example, from 2000 until April 29, the S&P 500 returned 5.4% while long investment-grade corporate bonds returned 7.7%.

This time period starts with high valuations in the US that lead into the Tech Bubble and ends coming out of the bottom of the global pandemic, but it is still worthwhile knowing. 

Below are two great charts from A Wealth of Common Sense by Ben Carlson. He looks at how often long-term government bonds and cash beat the S&P 500.

As you can see, stocks generally have better performance than bonds or cash, but they can go through long stretches where they underperform. During those time periods, there are usually significant ups and downs in the market that may cause you to waiver from your strategy. If that is the case, cash and bonds can be great investments. They also smooth out your investing experience. 

Interest Rates Will Go Up, Which Will Cause Bond Prices to Fall

Interest rates may go up. Typically, when rates go up, bond prices go down; however, people have been saying interest rates will only go up for the past decade and although they did a few times, we have lower interest rates than we did in the past. 

It’s impossible to time when rates will go up, the magnitude of the change, or how quickly it will happen. We may see a slow increase in rates over a long period of time. We may see rates spike overnight if inflation picks up. We may see low rates for the foreseeable future. 

Up until the past decade, nobody thought negative rates were possible, but near the end of 2020, there was more than $17 trillion of negative-yielding debt in the world.

While I think that is unlikely in the United States, you never know. If rates fell from this point, bond returns would likely be positive. 

Even though interest rates are low and likely to rise at some point, for most people, I can only make the case for being on the higher end of your risk tolerance – not investing 100% in stocks. For example, if you are normally comfortable around 70% stocks, maybe it is okay to be 75% or 80% stocks now given lower interest rates. 

Summary – Final Thoughts

Although people are fairly pessimistic about cash and bonds right now, they can be okay investments. Although they may feel like a drag on returns for years at a time, it only takes one crisis, such as March of 2020, for them to remind you of their importance. 

Like hiking, we bring items in our pack we never expect to use, but they are there just in case. Investing is a little different because we know there is a very good likelihood stocks will fall multiple times in excess of 20% throughout your lifetime. Cash and bonds prove their worth in those times. 

Remember, your cash and bonds help your stocks compound uninterrupted. That’s their purpose – not to earn high returns. They play a supporting role in your investment portfolio. 

Disclaimer: This article is for general information and educational purposes only and should not be considered investment, financial, legal, or tax advice. It is not a recommendation for purchase or sale of any security or investment advisory services. Please consult your own legal, financial, and other professionals to determine what may be appropriate for you. Opinions expressed are as of the date of publication, and such opinions are subject to change. Click for Full Disclaimer