Question: Can I use cash to provide diversification for the stocks I hold in my portfolio? With rising rates, it doesn't look like a great time to buy bonds.
Answer: The short answer is that cash can help offset one's equity risk. As you allude to in your question, cash won't lose ground during an equity downturn; nor will your cash depreciate in the event that rates move higher. But depending on your time horizon, bonds may be a better choice, especially when factoring in inflation.
Your Time Horizon
Right off the bat, there are a few unknowns that make this a tough question to answer. For one, everyone's investing situation is a little different. The "right" asset allocation depends on an investor's time horizon and risk capacity. For instance, an investor who will need funds in the very near term might be better off holding cash or a cash-equivalent investment. Although yields on savings accounts at major U.S. banks (so-called brick-and-mortar banks) are pretty miserly at the moment, some online banks (which do not have to bear the expense of managing branches, paying tellers, and so on) can offer rates close to 1%, and many times they also offer higher rates for money market accounts or certificates of deposit. Given that high-quality short-term bonds have yields that are barely higher than that, it's hard to justify the potential for principal volatility that can come along with bonds if your time horizon is very short.
But for investors who have a little more time--say, at least three years--a short- or intermediate-term bond fund can still make sense, even if you expect rates to rise. When weighing the pros and cons of bonds versus cash, it's important to remember that cash yields are so low that you're losing purchasing power when you factor in inflation, which could range from 1.8% to 2.3% for the remainder of 2015, according to estimates by Morningstar director of economic analysis Bob Johnson.
How High Will Rates Go?
The second thing that makes this question difficult to answer definitively is that we don't know when and how quickly interest rates are likely to rise, and how high they'll go before it's all over. But many industry observers and Fed-watchers think that long-term rates aren't likely to rise quickly; according to a Wall Street Journal economic forecast, consensus estimates expect the 10-year yield to slowly rise to 3.7% through December 2017. That would limit the pain a bondholder would take, even among core holdings in a bond portfolio. (Most funds in the intermediate-term bond Morningstar Category have an average effective duration of around five years. For a few quick tricks that can help you determine how rate-sensitive your bond holdings are, you could check out Morningstar director of personal finance Christine Benz's article, "How to Stress-Test a Portfolio's Interest-Rate Sensitivity".)
"People have been worried about rising rates for most of the past five years (or more) and, aside from 2013, it's generally been a pretty benign rate environment, and you've been better off in bonds than cash. It's hard to time markets, so it's better to build a portfolio that makes sense and stick with it," said Morningstar analyst Sarah Bush.
Greater Portfolio Diversification
Another consideration is portfolio diversification, or the correlation of your underlying assets. Whereas cash won't lose money during an equity-market shock, nor will it gain. Meanwhile, bonds can actually have a negative correlation with equities. During flights to quality, high-quality bonds (an important distinction) and equities are often (though not always) negatively correlated, said Bush. According to data available in Morningstar Direct, the correlations run near zero for the three- and 10-year periods and negative for the five-year period. The basic reason is that if you get a slowdown in the economy or a flight to quality (wherein investors get worried about risk), high-quality bonds (especially Treasuries/high-quality corporates) benefit from that fear. Bond prices rise and yields fall. Cash doesn't move, so bonds would provide better diversification in this scenario. (For more on this, see Christine Benz's article "The Best Diversifier Has Been the Simplest".)
Finally, it may pay to take a look at how professional asset-allocators have approached the cash-versus-bond question. In his article "How the Pros Manage Assets for Retirees", analyst Jeff Holt examines the allocations among target-date funds geared toward investors in retirement (those of the 2005, 2010, and 2015 vintages) and points out that the average 65-year-old target-date investor holds 7% cash. The allocation to cash is important for the preservation of capital, but one concern is that inflation will eventually erode a retiree's purchasing power. Alongside this cash position, many in-retirement target-date funds devote an ample slice of assets to bonds and equities. Treasury Inflation-Protected Securities (TIPS) have also become prevalent within target-date series, Holt notes, with the average allocation to that asset class ramping up in the retirement phase--peaking at 8%, on average, for a 75-year-old investor.
That said, Christine Benz points out that it's difficult to come up with one-size-fits-all cash allocations without knowing an individual's spending plans; therefore, she recommends that retirees use their own spending needs to determine how much to hold in cash.
Have a personal finance question you'd like answered? Send it to TheShortAnswer@morningstar.com.
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