Cash, Bonds or Equities: Where to invest your money and why

Cash, Bonds or Equities: Where to invest your money and why

There are three types of asset classes into which you can place your money: cash, bonds and equities. While it may be easy to differentiate one asset class from another, determining which asset class to invest in, and how much of your money to allocate towards each, can be a challenge. I have seen many investors’ portfolios constructed without the understanding of the reasons behind their choices. Not having the basic understanding of why you are placing your money in each asset class could be a contributing factor in why you are falling short of your financial goals. Hopefully this article will help you determine what percentage you invest in each asset class and why. CASH First, let us consider cash. This is where you would have your money in a savings/chequing account, Treasury bill, money market fund or a bond with less than one year left on its maturity. These all allow you to access your money virtually on a moments notice. The recommended purpose of holding cash is for emergencies, to cover off any temporary unemployment or to provide a financial bridge until your long term disability insurance begins to pay out. Financial planning manuals suggest having at least three months (after tax income) in cash. My recommendation is that it be anywhere from three months to two years depending on one’s age; the older a person is the longer the time frame. As for historical returns, cash has returned approximately 3%* which makes it a poor long-term investment. BONDS Next are bonds. This is where you loan your money to a government or corporation and the issuer guarantees the return on principle at a future date and pays you interest during the time it’s held. In my experience, investors have tended to primarily buy and hold bonds for the perceived safety they offer, for the emotional comfort that they get from being free from the ups and downs of the stock market, or for income. I don’t think that any of these are primary reasons to acquire bonds. Bonds, in my view, are best owned for the purpose of making available a specific sum of capital that you may anticipate wanting inside a five year time period, even though you can buy bonds for up to thirty years in duration. The idea is to time your bonds to mature when you will most likely need the money: when you are planning to buy a new car, a cottage or a home renovation. Historically, rates of returns on bonds have been approximately 5.5 %* which makes them a sub par asset class for long term investing, at best. EQUITIES The last asset class is equities. These are common shares of publicly traded companies that can be individually owned or professionally managed. I fully recognize that a home, cottage and other type of real estate fit this asset class, however, for the purpose of the article publicly traded companies will be the form of equities discussed. As an asset class equities have returned over 10%*, which makes it the superior asset class to invest in. WHAT NEXT? With this information, how do you determine what amount you place in each asset class? It really boils down to a process of elimination. You identify the amounts you wish to allocate to the first two categories and what is left over simply goes into equities. TWO THOUGHTS YOU MAY FIND You may find at least two thoughts come to mind when determining your allocation. The first is how bonds are recommended primarily for future sums of capital as opposed to income or safety. My guess is most of the investing public will think just the opposite and their portfolio may reflect so, meaning they will hold a certain percentage of bonds for income and/or comfort regardless of what rate of return they pay. Second, if this process is followed, the likelihood of an investor having the largest percentage of their portfolio in equities will be very high regardless of their age. First, because inflation and taxes erode the purchasing power of bonds over time, bonds by definition become, in my view, a poor financial investment. Yes I agree, they are popular and allow one to sleep better at night, at least on the short term. Yet it is a mistake to ignore bonds historical rates of return. Investors who have a very large percentage in bonds may wake up one day in their later years wondering why their money no longer has the same purchasing power it once did. As one of my industry colleagues adeptly put it, the only sane test of an asset class’s safety is to the extent to which it preserves or even enhances ones purchasing power. Bonds have so far failed in this area. It is important to note that while I am providing you a point of view that may challenge the conventional wisdom of owning bonds, please keep in mind there are investors that do have different approaches and objectives based on ones level of sophistication and net worth. In other words they may be perfectly fine owning bonds for reasons other than what is outlined in this article. Second, because we are living longer and having more active lives with each successive generation, we will require more money to preserve the lifestyle to which we have become accustomed. I know people who have being retired longer than they actually worked! I have found that as investors grow older they tend to invest more conservatively. By that I mean their risk tolerance for equities seems to decrease and their desire to inherently own more bonds in their portfolio increases. This occurs at precisely the time when, in my view, they need to hold a much higher percentage of equities in their portfolio than they are most likely emotionally comfortable. Again this approach may differ for a certain percentage of investors given their level of sophistication, net worth and objectives. ANSWER THIS QUESTION Answer this question: When it comes time to withdraw money from your overall portfolio, do you wish to attempt to recover 5.5%* a year during your retirement for say the next thirty years from an asset class that has had a historical return of 5.5%* or is it safer to attempt to receive 5.5% a year from an asset class that has had a historical return of over 10%*? With this awareness, choosing how much you allocate your portfolio to each respective asset class may determine whether your money and the income it derives for your retirement outlives you or you outlive it. Personally, I like the former outcome.