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Bonds in a Portfolio

Cash vs Bonds vs Equities

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Cash vs Bonds vs Equities

When Treasury bills yield 5% and the stock market is expensive, the choice between cash, bonds, and stocks changes. We'll explore the trade-offs and when each makes sense.

Key takeaways​

  • Cash (money market, T-bills) now offers competitive yields (4–5%) without volatility; it's not a fourth-rate option
  • Bonds still offer better risk-adjusted returns than cash over multi-year horizons, but the gap has narrowed
  • Equities remain the only asset class offering 8–10% long-term returns, but valuation matters
  • The choice depends on your time horizon: cash for 0–2 years, bonds for 2–10 years, equities for 10+ years
  • Portfolio construction now often includes all three, rather than just bonds and equities

The cash renaissance​

For decades, holding cash meant earning 0.01% at a bank or accepting inflation losses. In 2023, the landscape changed. The Federal Reserve raised rates to combat inflation, and money market funds, high-yield savings accounts, and Treasury bills began yielding 4–5% annually.

This is significant because it changes the calculus. Let's compare three ways to hold $10,000 cash for two years:

Option 1: HYSA at 4.5%

  • Year 1: $10,000 × 1.045 = $10,450
  • Year 2: $10,450 × 1.045 = $10,920
  • Total return: $920 (9.2% over two years)
  • Risk: essentially zero

Option 2: AGG (Aggregate Bond Index) at 4.7% yield, assuming 0% price appreciation

  • Same $920 return
  • Risk: modest (bond prices fall if yields rise)

Option 3: S&P 500 at 8% expected return

  • Expected value after two years: $10,000 × 1.08² = $11,664
  • Expected return: $1,664 (16.6%)
  • Risk: substantial (market could fall 30%)

For a two-year goal, the return difference between cash and stocks (0.74% annually) might not justify the volatility. Cash wins.

But extend the horizon to ten years:

Option 1: HYSA at 4.5%

  • Year 10: $10,000 × 1.045¹⁰ = $15,530
  • Total return: 55%

Option 2: AGG at 4.7% yield plus assumed 0.5% price appreciation per year

  • Estimated: $10,000 × 1.052¹⁰ = $16,470
  • Total return: 65%

Option 3: S&P 500 at 8% expected return

  • Estimated: $10,000 × 1.08¹⁰ = $21,589
  • Total return: 116%

Over ten years, stocks outpace both cash and bonds substantially. The volatility is harder to stomach in year 1 or year 5, but it's justified by the long-term return premium.

Cash is no longer a placeholder​

Historically, financial advice treated cash as a placeholder—something to hold until you could invest it in "real" assets like stocks or bonds. But with money market yields at 4–5%, cash has become a legitimate asset class.

This is especially true for near-term goals and emergency funds. The old rule was to hold three to six months of expenses in cash "for safety." But with cash earning 4.5% and stocks earning an uncertain return in the next 12 months, holding a 12-month cash reserve (not three months) is rational.

A concrete example: You earn $100,000 annually (roughly $8,300 monthly). An emergency fund of six months ($50,000) earning 4.5% yields $2,250 per year—enough to meaningfully offset the cost of maintaining that reserve.

The bond-cash trade-off​

Cash and bonds are close substitutes on the spectrum from zero risk to maximum risk. The choice between them depends on two factors: how long you'll hold the money and whether yields are likely to rise or fall.

When cash wins:

  • You need the money in 0–2 years
  • Yields are high and likely to fall (you want to lock in today's high yield)
  • You expect volatility (you want certainty)
  • You're uncomfortable with price fluctuations, even small ones

A 60-year-old who just received a $200,000 inheritance and plans to live off it for 30 years should hold three to five years of spending in a money market fund or T-bill ladder (rolling 1-year T-bills), not in bonds.

When bonds win:

  • You can hold for 3+ years
  • Yields are moderate and stable
  • You can tolerate modest price fluctuations
  • You want slightly higher yield than cash offers (0.5–1% per year)

An investor with a 10-year time horizon can earn an extra 0.5% annually by shifting from money market (4.5%) to intermediate bonds (5% aggregate yield, assuming modest price changes). Over 10 years, that extra 0.5% adds up to meaningful capital.

The equity premium​

Equities (stocks, equity funds like VTI) have historically offered 8–10% annualized returns over long periods. Bonds have offered 4–5%, and cash has offered 2–4% (or 0.01% in the low-yield era). The equity premium—the extra return you earn for taking equity volatility—is roughly 3–5% per year.

But the equity premium is not consistent. In some decades (1980s), it's 6%+. In others (2000–2010), it's 1–2%. In some years (2023), bonds outpace stocks. In others (2017), stocks are 4x as good as bonds.

The key question: is the equity premium worth the volatility? The academic consensus is yes for time horizons of 10+ years. Over 10 years, an equity allocation almost always outpaces bonds, even including bear markets and recessions.

But for 5-year or shorter horizons, the equity premium might not be enough. The risk of a 30% loss in year 4 or 5 is real, and the expected return premium might only be 1–2% annually. In that scenario, bonds or cash make sense.

A three-asset framework​

Here's a practical framework for allocating between cash, bonds, and equities:

Cash (0–2 year horizon)

  • High-yield savings account: 4.5%
  • Money market fund: 4.5%
  • Treasury bills (3–6 month rolling): 4.5%
  • Risk: none
  • Use case: Emergency fund, near-term goals, psychological stability

Bonds (2–15 year horizon)

  • Intermediate bonds (BND, AGG): ~4.5% yield, ±5% price volatility
  • Long-term bonds (TLT, VGLT): ~4.5% yield, ±12% price volatility
  • Risk: modest (price fluctuation, inflation)
  • Use case: Near-retirees, mid-term goals, ballast for stocks

Equities (10+ year horizon)

  • U.S. broad market (VTI, SCHB): ~8% expected return, ±18% volatility
  • International stocks (VXUS, IEMG): ~8% expected return, ±20% volatility
  • Dividend stocks (VYM, SCHD): ~6–7% return, ±15% volatility
  • Risk: substantial (40–50% bear markets)
  • Use case: Long-term wealth building, retirement, career-building years

The modern portfolio triangle​

When cash outpaces bonds and stocks​

There are rare windows when holding cash is optimal. 2023 was one of them. With money markets yielding 5.0% and the S&P 500 entering the year at a 16x earnings multiple (implying ~6% expected returns), cash was competitive. With a 10-year Treasury at 4%, bonds offered no meaningful premium to cash either.

In that regime, a portfolio of 100% money market was not unreasonable for a retiree or someone with low risk tolerance. You earned 5%, had zero volatility, and waited for a better entry point into stocks.

This illustrates an important principle: asset allocation is not fixed. As yields and valuations change, the attractiveness of each asset class changes. A portfolio that was optimal in 2020 (when bonds yielded 0.5% and stocks were cheap) is not optimal in 2026 (when yields are higher and stocks are at fair valuations).

Next​

We've covered how to size bonds in good times. Now we turn to the regimes when bonds fail to deliver their job: inflation and deflation. We'll start with deflation, where bonds become the clear winner.