When Bonds Make Sense in Your Portfolio—and When Cash Is the Better Option

Daftar Isi

The most well-known investor of our time, Warren Buffett, among other notable investors of this era, largely avoids bonds and keeps his cash in cash. Should you be duplicating that approach with your own portfolio?

Warren Buffett has a incentive to play things extra cautious. In addition to investing in stocks, Buffett's company, Berkshire Hathaway, also makes huge insurance bets that could require it to pay billions of dollars in claims. With cash, he knows the money will be there regardless of what happens on the market.

from New York Life.

In some cases, the opposite can happen within a shorter timeframe. For example, in 2022, the year the Federal Reserve started increasing interest rates to combat inflation, the Vanguard Intermediate-Term Treasury Fund Admiral Shares fell by 10% and the Vanguard Long-Term Treasury Fund Admiral Shares dropped by 30%. Meanwhile, investors in the Vanguard Federal Cash Reserves Federal Money Market Fund Admiral Shares actually saw their money grow 1.6% that same year.

It didn't stop there. By 2024, with interest rates still fluctuating wildly, that same long-term Treasury fund from Vanguard had lost 6.3% of its value, while the intermediate-term Treasury fund managed only a small gain of 1.5%. Meanwhile, the Vanguard money-market fund yielded a respectable 5.2%.

It's unclear what the future holds for interest rates. If you're a saver who's counting on having a large sum of money for a significant expense within the next year or two, such as a house down payment, it's best to keep that money in cash.

The current interest-rate situation is quite unclear. The Trump administration's plans for tax cuts and tariffs could lead to bigger budget deficits and fuel inflation. The uncertainty is significant, causing some investors to keep a large portion of their funds in cash for the time being.

“With the Fed focusing on the ups and downs of interest rates, Congress preoccupied with shifting power dynamics, and markets wildly swinging in response to current events, we're relying on our cash reserves to protect ourselves from the frenzy until stability returns,” said Scotty C. George, chief investment strategist for Arlington Econometrics.

Investment expert Larry Swedroe, who wrote "The Only Guide to a Winning Bond Strategy That You'll Ever Need," is also cautious about owning long-term bonds now because widespread deficit spending could lead to inflation.

We've hit a point where the impact on growth is significant," Swedroe says. "There are concerns about our capacity to finance our deficits.

So Swedroe, who has typically recommended that investors hold medium-term bonds, suggests investing in short-term bonds or cash at the present time.

The tougher question is whether holding cash in the long term makes sense. Christine Benz, director of personal finance and retirement planning for Morningstar, advises working individuals to keep three months to a year's worth of expenses in cash in case they lose their job or have an unexpected emergency.

For retirees who are withdrawing from their retirement funds, Benz recommends they keep one to two years' worth of living expenses saved, in addition to their Social Security payments, to ensure they don't need to sell stocks in the event of a market downturn.

“For the short term, cash is a safer option. However, our historical data indicates that, in the long run, bonds will do better than cash and also provide a bit more protection against inflation.”

Personal money manager and financial author William Bernstein disagrees. Bernstein, who recently published the second edition of "The Four Pillars of Investing", suggests that retirees should invest heavily in a step-up ladder of Treasury inflation-protected securities bonds. With current interest rates, placing $1 million in a TIPS ladder would allow you to withdraw $46,000 annually, adjusted for inflation, for the next 30 years.

For those who are still working, Bernstein suggests they use a combination of stocks and cash for two key reasons. First, he says that cash will protect against unexpected emergencies. Second, the stability offered by cash can also make investors more likely to weather future stock market downturns without panicking and selling.

I'm not going to debate Warren Buffett on this," Bernstein says. "He's aware that in a small percentage of cases, your ability to pay your bills can depend on having cash on hand.

Philosophers like Buffett and Bernstein tend to be in a minority when it comes to investing in cash vs bonds. Financial advisor Susan Elser from Indianapolis recommended shifting her clients into slightly longer-duration bonds a year ago, stating that she and others had expected interest rates to decrease and bond prices to rise. However, interest rates have actually increased in recent months, causing losses for the bonds.

But Elser isn't swayed from her opinion that bonds make more sense over the long haul than cash. She points out that bonds have outperformed cash over a large part of the past 20 years.

In 2020, bondholders benefited financially when interest rates dropped at the outset of the Covid-19 pandemic, according to Elser. "People were enthusiastic about holding bonds due to the gains resulting from declining interest rates," she points out. "However, five years later, people now view bonds as poor investments."

She says, “In times of rising interest rates, you're usually better off with cash than bonds. However, the assumption is that everyone knows when rates are increasing, and no one actually does.”

neal.templin@barrons.com