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The Role of Risk-Free Assets in Your Long-Term Portfolio

The Role Of Risk Free Assets In Your Long Term Portfolio Splash image

What is a risk-free asset, and what role should it play in your portfolio?

That’s one of the first questions many investors ask when struggling with the asset allocation question.

In today’s market environment, the sudden and steep drop in the stock market as well as anxiety over the future of the banking industry and the financial health of long-term bond issuers have all caused a massive rush to—and an exclusive focus on—“risk-free” assets.

Yet only two years ago, these assets appeared “boring” to many investors who—at that time—were focused on the long-term return and current income attributes of the major asset classes (stocks, bonds and cash).

But neither of those perspectives produces a useful guideline. Instead, the role these assets play in your portfolio should be based on a perspective that encompasses both long-term and short-term considerations.

What Asset Is Risk-Free?

In the investment world, risk is typically associated with uncertainty in terms of returns: The greater the uncertainty surrounding future returns, the greater the risk. A risk-free asset is one with a certain future return.

In the real world, short-term Treasury bills come as close as possible to being risk-free because they are backed by the U.S. government (no credit risk), and because their maturities are short (no interest rate risk—the risk that changes in interest rates will cause the underlying value of the security to change).

For these reasons, Treasury bills are often used by investment theorists and analysts to define a “risk-free asset.”

For individual investors, Treasury bills offer the most complete protection in terms of credit risk, but other “cash” investments (low-risk money market funds, short-term CDs, etc.) are practical alternatives.

No Such Thing as No Risk

While these assets offer real protections over short-term horizons, it is important for long-term investors to keep in mind that, despite the risk-free label, Treasury bills and other short-term cash investments do contain two very important long-term risks:

  • Inflation risk: The long-term returns from Treasury bills and cash investments have been the lowest of the three main asset classes, offering virtually no growth above the rate of inflation. For example, since 1926, the long-term real (after inflation) rate of return on Treasury bills has averaged roughly 0.7% annually. Taxes can take a further bite out of returns. Thus, if cash is held in a taxable account, your aftertax return could easily be below the rate of inflation.
  • Income risk: Treasury bills and cash investments face the risk that the income provided will fall sharply in a relatively short time, in tandem with declining short-term interest rates. Short-term interest rates are much more volatile than long-term rates over time. For example, returns from Treasury bills climbed from 4.9% in 1977 to 17.1% in 1981, they declined to 8.7% in 1983, and in 2008 they averaged a mere 2.0%. In mid-March 2009, three-month Treasury bills were yielding 0.45%.

Putting It Into Perspective

Treasury bills and other cash investments have the advantage of liquidity and little downside risk, but no real long-term growth, and typically the income is the lowest among fixed-income alternatives. The investment attributes allow cash to serve several purposes within an investor’s portfolio:

  • It serves as a ready source for spending money and for protection against emergencies, so that longer-term investments need not be liquidated at inopportune times.
  • It serves as a stabilizer for your overall portfolio, tempering the overall downside risk of what may otherwise be a very volatile portfolio.

Spending & Emergencies

What’s the minimum amount individuals need to keep for spending and emergencies?

One popular rule of thumb is that cash reserves should equal six months’ to a year’s worth of take-home pay or living expenses. But this rule of thumb applies primarily to people who are working.

Individuals who are working really don’t need to maintain a large “spending” account, since they have a ready source of monthly income to meet expenses. The amount needed for spending is a function of personal preference in terms of how much you desire to have on hand to meet expenses, particularly for upcoming major purchases.

On the other hand, individuals who are working do need emergency cash reserves to protect against a major loss—primarily a loss of income due to loss of work or disability.

Assuming you are properly insured, disability insurance should eventually cover most of any income shortfall due to a disability. In this case, your primary liquidity need would be during the waiting period when there are no disability benefits; the shorter the waiting period, the less there is a need for liquidity. On the other hand, a loss of income may occur that is not covered by disability insurance—for instance, a cutback or firing. If this were to occur, you would need enough income to offset expenses over the time you are out of work. The best way to determine this liquidity need is to estimate your monthly living expenses and assume that those expenses need to be covered for some time—six months to one year.

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Retirees have somewhat different emergency and spending needs.

While the financial emergency that threatens workers is the loss of salary income, a retiree living off of investment income is concerned with fluctuations in savings due to the volatility of the markets.

The major protection from this risk is a diversified asset allocation plan, which includes a large enough commitment to low-risk liquid cash assets so that you are not forced to sell stocks or longer-term fixed-income assets during a protracted market downturn.

For example, if you want to protect your longer-term assets from forced sales over a five-year period (roughly, a full market cycle), and you plan on withdrawing 4% of your investment portfolio in your first year of retirement for income, you would want to allocate at least 20% of your investment portfolio to low-risk liquid cash assets.

Of course, retirees who are living off of investments also need cash accounts from which to withdraw spending money. The size of this cash reserve would depend in part on the frequency with which you rebalance your investment portfolio and add to your spending account. Less frequent rebalancing may be more convenient—and less time-consuming at tax time—but it will cause the spending account to fluctuate more. Whether this cash account is combined with the cash reserves used to protect your longer-term assets against having to sell at inopportune times is a matter of comfort and convenience.

Tempering Volatility

A separate function of cash within an investment portfolio is to temper portfolio volatility that is the result of investments in riskier asset classes.

In general, stocks provide the most growth. Bonds and cash produce a steadier source of income than stocks do; a much larger percentage of their annual return comes from income rather than growth. Cash has an advantage over bonds of immediate liquidity, but the disadvantage of lower levels of income.

While cash tends to have higher income risk than longer-term maturity bonds, it does not face interest-rate risk. When interest rates rise, a bond’s value will drop, and the longer the maturity, the greater the drop, all other things equal. It is this characteristic of cash investments—virtually no downside risk over the short term—that makes it quite useful when combined with more risky, growth-oriented investments in an investment portfolio.

Adding cash to the portfolio mix can allow you to lower your portfolio’s downside risk, or it can allow you to increase your investment in more growth-oriented stocks without increasing your downside risk.

While increasing your stock exposure may not seem particularly appealing in the current market environment, stocks do offer the only real protection against inflation risk—the risk that your portfolio will fail to grow in real (purchasing power) terms over the long term. Investment portfolios with stock commitments below 50% face the substantial risk that the portfolio will not grow enough to sustain annual withdrawals that can keep pace with inflation throughout your retirement period.

Cash Benefits

Here are some thoughts to keep in mind when pondering the role of “risk-free” assets in your portfolio:

  • There is no such thing as a truly risk-free asset for long-term investors. Treasury bills do not face credit risk or interest rate risk, but they do face inflation risk (offering virtually no growth above the rate of inflation) and income risk (the income they provide may fall sharply in a relatively short time, in tandem with declining short-term interest rates). What appears to be risk-free and stable may in fact translate into a declining amount over longer time periods if it doesn’t increase with inflation.
  • Treasury bills and other cash reserves should be kept so that you are not forced to sell long-term investments at inopportune times due to unexpected emergencies or at major market downturns in which you do not want to sell stocks for an extended time period.
  • A substantial commitment to stocks will most likely be needed to provide growth and prevent a loss in real terms of the value of your long-term investment portfolio. But Treasury bills and other cash investments can be used to moderate the downside risk introduced by a large stock component and investments in more aggressive stocks.


Discussion

John from NE posted over 3 years ago:

Bills, notes, bonds--include in that zero coupon bonds, when held to maturity, and laddered, can provide some security in terms of return to your portfolio. Changes in interest rates can affect the value of what you get on the return, but the investor has a set rate of return, unlike stocks. This makes for a more predictable part of the portfolio. I'm hoping that, like stocks (through direct purchase, funds and ETFs), this market will become more easy for the individual retail investor to participate in both on a cost basis and as far as access to information is concerned. Time will tell.


James from FL posted over 3 years ago:

I keep about $200,000 in cash reserves.


Jim from CA posted over 3 years ago:

I have about 18% of my investments in cash and very short term bond funds. I am worried about interest rate risk, and the role of these investments is to reduce my fixed income investment duration. I feel there are additional risks to cash as an investment. First, in cash form, it is more likely to be spent! Second, it does not keep up with inflation (effectively looses one of two percent in purchasing power per year). Personally, I don't like cash at all, and have it only because of my concerns about the probability of rising interest rates, which cause long duration bonds to significantly loose value.


Santosh from CA posted over 3 years ago:

In these uncertain times having a cash of 30% is safer. We want higher returns but our economy is fragile. we (USA) are broke and so is Europe.
If austerity is imposed, we might see another deep recession. Japan is suffering from deflation for over 20 years. And no end in sight.
Unless the super-rich are willing to pay their due share of taxes, we can end up less money in the hands of middle class. If people stop investing in the stock market, billionaires cannot make money through the Wall Street gimmicks like derivatives and hedge funds. We are at the mercy of the supr-rich. It is a gambling casino for many of us.
My suggestion is play safe.


Paul from CA posted over 3 years ago:

I keep three years of cash on hand, either cash or very short term bonds. If at the end or even during the year if we have experienced a up tick I will take out another year. If there is a down turn in the market I can sit on the side for three years if needed.


Joan from CA posted over 3 years ago:

We're holding 2 years of cash and $186,000) in I bonds. ( Purchased in 2001.)


Charles from LA posted over 3 years ago:

There was a book titled "Buckets of Money" that has provided me with my retirement allocation plan
o Bucket One had 5 years of cash and short term bonds
o Bucket Two had 5 years of longer term bonds
o Bucket Three had the remainder in equities
The approach then called for me to spend Bucket One money down over the next 5 years (this allows the other Buckets to grow and avoids selling equities during market downturns) and then you redistribute or refill the buckets a the end of 5 year.


Jack from CA posted over 3 years ago:

I'm retired and keep a two and a half year supply of money on hand at all times. Every four to six months I replenish it regardless of what the market is doing.


John from MI posted over 3 years ago:

I keep 2 years in cash and 305 invested in income and short term funds. The rest is in ETF's that will go south for 3 years only if the world ends financially.


Robert from IL posted over 3 years ago:

How about that lost decade in equities?


Judith from OH posted over 3 years ago:

I used to keep one year of cash but now have seven, which is too much. It amounts to 20% of my portfolio. There's so much uncertainty now I'm reluctant to be fully invested, but real inflation is killing me.


Paul from MI posted over 3 years ago:

I think that if you have pension, social security, and investment income that covers living expenses, then there is little need for large cash reserves. As a 80 year old retiree I have 60% in fixed income (bonds), 30% in dividend paying stock, and the balance in a govt money market fund.

I use my cash reserve to fund my "rounds of pleasure".


Marlin Matlock from CA posted about 1 year ago:

We keep 6 to 8 months in cash. We keep the equivalent of 6 mo. in high grade muni bonds.
With the impending increase in inflation I fear that the cash will actually lose value faster than the return it is earning.


Gerald Alfredson from IN posted about 1 year ago:

We keep 5 yrs in cash and only convert to cash on a monthly basis when the market is "up". I have a spread sheet that tells me when that is. We have a small (1 yr) amount in a junk bond fund that is part of that cash category. All the rest is in equities which is mostly stock mutual funds.


Ron from IL posted about 1 year ago:

Over the last three months, I have been moving my bond allocation to money markets in my IRA account. I feel that with bonds losing money with rates going up, I can use this money to consider adding to equities if we have a correction later this summer. I have been 50% equities and 50% bonds. I am now 50% equities, 25% bonds and 25% money market funds.


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