Trade-Offs In Action
“Jeff, how do you balance the trade-offs when allocating to bonds in your own account and in the Model Portfolios?”
I saw many versions of that question come in from subscribers after I shared the latest installment of the Bonds 101 series, Balancing Trade-Offs. So, before moving on to some other topics, I thought it might be helpful to discuss how I put the framework I shared into practice.
As a reminder, here are the trade-offs I discussed:
When choosing between short- and long-maturity bonds (or bond funds), you are picking between price stability and income stability. Short-maturity bonds have more stable prices, but the income you receive will change more frequently. If you buy a long-maturity bond, expect its price to rise and fall more dramatically, but the amount of income you collect is more consistent over time.
The second trade-off comes when picking between high- and low-quality bonds. High-quality bonds (think U.S. Treasurys) typically hold up better when stocks are falling, but they pay less income and their prices are more sensitive to changes in interest rates. Lower-rated bonds (think junk bonds) rise and fall roughly in step with the stock market but pay more income, and their prices are less responsive to interest-rate moves.
Now, here’s how I balance these trade-offs—first in my personal “cash management” accounts, and then in the Portfolios:
When I manage my family’s money, I, Jeff DeMaso, emphasize price stability for immediate spending needs, emergency funds and near-term spending (say, within the next two to three years). I consider this “cash management”—it is distinct from my long-term investment portfolio, but it forms the foundation of my financial life.
When it comes to immediate spending—think groceries, transportation, medicine, rent, a trip to the zoo—this money needs to accessible and safe, and its price had better not change. This is where I want to be able to put a dollar in, know that it’s safe, and take that dollar out at a moment’s notice. Let’s call these “dollar-in/dollar-out” vehicles. To me, that’s checking and savings accounts, as well as money market funds.
An emergency fund is there to buffer our investment portfolios from the speedbumps we all inevitably encounter in life. I don’t plan to spend that money tomorrow, but it needs to be there when I need it. While the textbooks say I should use a dollar-in/dollar-out vehicle here too, I disagree.
Do I really need my emergency fund to never, ever fluctuate in value? No. As I said in the first sentence of this section, I emphasize price stability—I don’t demand it. I’m willing to own the likes of Ultra-Short-Term Bond (VUBFX) or Ultra-Short-Term Tax-Exempt (VWSTX, which was called Short-Term Tax-Exempt until the end of February) as part of my emergency fund if it gives me better odds that my cash sitting there will keep up with inflation. This was particularly true when money market yields were stuck at the near-zero bound.