Why Your Bond Questions Are Really About Cash (EP.235)

0:28We all need to make smart decisions with our money. these book updates, they go out every other Saturday. This is separate from my regular newsletter that goes out every other Wednesday with my latest content, links to all these articles, resources I'm reading. But these book updates, if you want them, you can sign up at theperfectportfoliobook.com or use the link at the top of the episode description. And when you join that list, you'll eventually get a peek at the book's outline. And I invite you to reply with your thoughts and questions. But what has caught me by surprise, and I think I've mentioned this in past episodes is how many of the replies are about bonds.

1:04And it's something I've seen throughout my career. Bonds, they're a topic where even the smartest people feel unnecessarily confused. And in many ways, they are a bit less intuitive than stocks. But I also think that the industry explanations don't help. So it was in this subscriber-only webinar for this book email update list where I had this, oh, that's what you're talking about moment. And a lot of these emails I'm now realizing really aren't about bonds in the portfolio. They're about bond ladders and what I would think of as cash management questions. It's not what should my long-term bond allocation be.

1:43It's closer to how do I avoid selling stocks in a downturn? Or how do I keep my plan intact if markets are getting ugly? Or how do I invest money that isn't needed in the next year or two, but that I don't want susceptible to market swings if I think I'm going to need it three, four, or five years from now? And this last question comes from a lot of readers, a lot of listeners who've been following my work for a while and realize I don't like individual bonds. And I think the common question that comes after they realize why I don't like individual bonds and probably why they and you should not like individual bonds is, what does that mean for my bond ladder?

2:21So that's what we're doing here today. We're not doing a bond primer. We're talking about designing a cash management system that lives outside your portfolio and is separate from your long-term bond allocation. Now, I like to always level set with the reason we invest, and that's simply just to grow our savings at a rate greater than inflation without outtaking undue risk. But because investing comes with volatility that's the cost of higher expected returns, you don't want necessarily to have your savings invested in there that are needed in the near term. So investing, that's for money that you can leave alone long enough for the volatility to be worth it.

3:02Cash, on the other hand, is the money that has to work on your schedule, not the markets. It shouldn't be expected to generate a return that outpaces inflation and, And in fact, long-term after-tax real returns on cash have historically been negative. So during your working years, cash is typically set aside for things like tuition, taxes, a known big bill, a down payment, a planned remodel, or just the life happens stuff like a roof leak, a car repair, big medical bill, job loss, etc. But when you're near retirement or in retirement, perhaps you're holding cash for some similar reasons, but my experience is that it's primarily for the next 12 to 24 months of retirement withdrawals.

3:46Now, the cost of cash is that your after-tax real returns are going to be negative over time. So I'm typically hesitant to insure against more than two years of price fluctuations. And when you look at the historical S &P 500 bear markets, the average round trip, so like when you go from the prior peak down to the low and then back up to the old high? That's been roughly two and a half years. Now, bear markets will last longer during recessions and shorter when there is not a recession. But in my mind, holding two years of cash allows you to avoid the worst version of forced selling, which is selling during the decline.

4:25So I mentioned it's two and a half years to do that round trip of a bear market cycle. Historically, it's taken the S &P 500 11 months to bottom out. So if you need to tap your portfolio before the market has returned to the previous high, you're more likely to be doing it during the stabilization or recovery period and not necessarily during the free fall. So I think going into retirement one to two years of cash is plenty, recognizing that yes, there will be periods where a bear market lasts longer than the two years you have on hand. But don't forget, we are just looking at the S &P 500. Theoretically, your portfolio is diversified in international stocks.

5:05Theoretically, there are bonds in your portfolio that are acting as a ballast for that volatility. And then theoretically, there's also income coming in from your holdings. So even these outlier events, the two that come to mind are 1972 to 1973 or 2000 to 2002, where it took three to five years for the full cycle to play out. But even in those longer cycles, the one to two years of cash can still do its job. It basically just reduces the odds that you're selling stocks while the market is sliding. Because the nightmare scenario for retirees usually isn't that the market goes down. It's more so that the market goes down and you have to sell into it to pay bills.

5:48I think that is the trap the cash bucket helps you avoid. Could you keep more than two years in cash? Absolutely. For some people, especially if their spending is very inflexible or you just know you'll sleep better, I think those are perfectly reasonable choices. But I do think you need to be aware of the trade-off that more cash buys comfort at the cost of inflation and missed compounding. If you want a second layer that pays a little bit more than cash, this is often where people look to bond ladders. And the appeal of bond ladders is probably certainty and control. You can point to the maturity dates.

6:25You can tell yourself, I get my principal back at maturity. And you can avoid seeing those daily price fluctuations the way that you do with a bond fund. So I get it. It feels calmer. That emotional comfort is real, but it does not eliminate risk. It really just changes the kind of risk you're taking. Now, for starters, and I've written so much about this, individual bonds versus bond funds, Using individual bonds is a very inefficient practice relative to bond funds. I don't even think it's a debate at this point. If you wanna scroll back to episode 223, that's the most recent time that I covered it.

7:00I will also link to that episode and a few others in the show notes at thelongterminvestor.com. But the short version is that individual bonds are more costly. No, they are not free. They are more costly. They are less diversified and they carry meaningful reinvestment risk. Now, the longer, more nuanced version will also point out that you are leaving a lot of return on the table without any sort of meaningful increase in risk by using individual bonds. If you have some sort of second layer of protection against a downturn that lives outside of your long-term portfolio, my preference is going to be to use ultra-short or short-term bond funds just because it's simpler operationally.

7:43it reinvests continuously, and it adapts more efficiently as yields change. This is all about cash management, and I tend to think that the bucketing system is an effective way to think about it. I see three buckets, basically, one of which is optional and arguably not necessary for most people who are listening to this podcast. There's the first bucket. It's the cash for expenses in the next two years. And during your working years, the opportunity costs of missing compounding seems way too high to have more than one year's worth of expenses in cash. But for retirees or people who are nearing retirement, I do think one or two years of cash seems like a reasonable amount that balances those opportunity costs of higher compounded returns with the insurance against selling investments during a bear market to meet living expenses.

8:35Now, cash should be kept in an online savings account or in a traded money market fund that is liquid, predictable, and unlikely to give you any sort of surprises. And when it comes to refilling that cash bucket, I'd suggest that you look at your target, that 12 to 24 months of spending in cash, you look at it annually as part of a year-end planning process. If you're above the target, great, leave it alone. If you're below the target, that's fine too. Refill it as part of your normal portfolio maintenance, often by trimming what's up the most in your long-term portfolio. Now, if you're in a bear market, and you want to allow your portfolio time to recover instead, then don't refill your cash bucket.

9:16Again, that's what it's there for. And here is the bonus behavior that I tend to let people get away with because I'm not a believer in market timing. And if your financial plan is in solid condition and you want to refill your cash bucket a bit earlier or in the midst of a downturn in hopes of avoiding more losses, this is sort of the one time I'll shrug my shoulders and say, sure, it's definitely an attempt to time the market, but it's also sort of this behavioral allowance that acknowledges, look, we're not all robots. And it's typically not going to impact in a noticeable way a financial plan that is already in solid shape.

9:51So that's bucket one, the cash bucket. Bucket two is strictly optional. And the word optional even bothers me a little because I think for most people, it's not really necessary. If you want a second layer of protection against a more prolonged downturn, but you also want it to pay a little bit more than what you'd earn on cash, this is where I think people often reach for bond ladders. So even while I don't think this bucket is optimal or necessary, I would say that if you can afford to pay for more insurance against market volatility in the form of lower returns, my preference is going to be using ultra short or short-term bond funds rather than a bond ladder.

10:33And when you have this type of bucket, you'll want to make sure that the interest payments are automatically invested into the fund and that it's your first source of funding the refill of your cash bucket. Now, before you start thinking, well, I don't want to see price declines in a bond fund, I'm going to make this really simple. I mean, it's an opportunity to do a deep dive, but again, I'd say scroll back to episode 223 or go to thelongterminvestor.com where I'll link to some other stuff that explains this in more detail. But here's the simplest thing. If your holding period is longer than the duration of the fund that you own, any increase in interest rates will actually enhance your returns relative to owning individual bonds.

11:16It's that simple. So an ultra short fund is often going to have a duration of one. What we're talking about here are savings that would be for three to five years out. So if you're in a short-term bond fund and the duration is three and interest rates go up a percent, you are likely to see about a three percent decline in your bond fund. However, three years later, once your holding period equals the duration, because it's been reinvesting at higher interest rates, you're back to even as if it wouldn't have been anything and you are going to start being better off than being locked into the bonds that you might have otherwise been in on day one.

11:51So yes, temporary price decline. Again, some of these other episodes I point to really show why price decline is not that big of a risk, especially if your holding period is longer than the duration of the fund. Now, bucket three, that's just everything else. The rest of your savings should be invested in a long-term portfolio that mixes stocks and bonds that's aligned with your risk tolerance. And the use of bonds in this bucket is to reduce the overall volatility you experience. The more bonds you use, the lower your expected returns. And deciding how much you should have in bonds is what we're going to be discussing next week.

12:27So be sure to tune in. And if you found this episode useful, please do consider leaving a review in your podcast app. It helps the show grow and it lets more people find information to help them make good decisions with their money. As always, thanks for listening. And until next time to long-term investing. Thanks for listening to the Long-Term Investor Podcast. To access free financial resources and submit questions to be answered on the show, visit thelongterminvestor.com. Peter Lazaroff is an employee of PlanCorp and BrightPlan. All opinions expressed by Peter and any podcast guests are solely their own opinions and do not reflect the opinions of PlanCorp or BrightPlan.

13:10This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of PlanCorp and BrightPlan may maintain positions in the securities discussed in this podcast.