A while back, a Tel Aviv woman named Anat decided to surprise her elderly mother with a gift. Noticing that she had been sleeping on the same worn out mattress for decades, Anat replaced it while her mother was out one day. She then took the old one out to the curb.
It wasn’t until the next morning, though, that her mother noticed the change and asked what had happened to the old mattress. Anat explained that she had put it out with the trash, which had since been picked up. This sent her mother into a panic because, it turned out, she had hidden her life’s savings in that old mattress—more than $1 million. According to news reports, they searched three different dumpsites across the city but never found it.
When I mentioned this story to a colleague, he described something similar. When his grandfather passed away, he helped clean out his house. In the freezer they found several packages labeled “fish.” But they caught his eye because, as he said, “there were a lot of them, and they didn’t look like fish.” As you can probably guess, when he opened them, he found piles of cash.
These stories are both funny and not funny at the same time. And it turns out they’re not so unusual. According to a Marist College poll, people hide money in all kinds of places. More than 10% hide cash under the mattress. Even more hide money in the freezer. Other popular spots include the sock drawer and the cookie jar. And there’s also the back yard.
I don’t recommend holding cash in your home like this (unless it’s in a safe), but I see the emotional appeal. A pile of cash is tangible in a way that a bank balance isn’t. Especially in a volatile world, it’s comforting to have a stable asset. What’s interesting, though, is that with today’s low interest rates, many people seem to have gone to the other extreme and are shunning conservative investments. Prominent voices like hedge fund manager Ray Dalio are saying, “cash is and will continue to be trash,” and bonds are “stupid.” Why is he so negative? Because today’s low interest rates mean that most bonds aren’t keeping up with inflation. Even Warren Buffett, who is far less of a gunslinger than Dalio, has said, “…people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value.”
I understand this sentiment, but I don’t agree. I think it’s a matter of perspective. If you look at cash or bonds as a vehicle to make money, then you’re almost guaranteed to be disappointed. In my opinion, though, that’s not why you want to own them. With cash and bonds, you’re not trying to make money. Instead, they are insurance, to help you avoid losing money.
In fact, I look at the bond side of a portfolio in the same way that I look at any insurance policy. Consider your homeowner’s insurance. If, at the end of the year, your house is still standing and you haven’t made any claims, would you consider the premium you paid to have been a waste? Of course not. We’re glad nothing bad happened and generally don’t give a second thought to the small price we paid for insurance. This is even more true with health insurance and life insurance. We buy insurance to protect ourselves from all of the things that could go wrong in life. In that way, dollars spent on insurance premiums aren’t wasted; they serve an important role.
Similarly, the role of bonds in a portfolio is to provide downside protection. In years when the stock market is down, that’s when bonds shine. When stocks were down more than 30% last year, retirees who needed cash to meet their living expenses hardly worried whether their bonds had lost a few percent to inflation.
In the finance literature, there is a framework called Roy’s Safety First Criterion. Published in 1952 by A.D. Roy, it provides a quantitative lens through which to see the value of bonds. Without getting into the math, the basic idea is that an investment should always be evaluated in relation to both its prospective return and its risk. Specifically, Roy’s formula uses the standard deviation of an investment—that is the variability of its returns from year to year—to measure risk. It’s through this lens that I think bonds begin to make a lot more sense. Consider the following data from Morningstar:
- Over the past 95 years, domestic stocks have returned, on average 10.3% per year, with volatility of nearly 20%.
- Over that same time period, short-term U.S. government bonds have returned 3.3%, barely ahead of inflation. But the volatility has been just 3.1%.
In other words, with bonds, you wouldn’t have gotten rich—but the losses, whenever they occurred, wouldn’t have caused you to lose much sleep. Here’s another way to look at the numbers. Over that same time period, the worst year for an all-stock portfolio was a loss of about 43%. Meanwhile, the worst year for an all-bond portfolio was a loss of just 5.1%. That is the value of bonds.
Won’t bonds lose value if interest rates rise? Yes, that’s a valid concern, and we’ve seen some of that this year. That’s why I’d stick with short- and intermediate term bonds, which have the least sensitivity to interest rates. And I would invest in only government bonds. Of course, these bonds pay the least interest, but they also provide the greatest stability. The way I see it, if you’re going to buy insurance, you shouldn’t cut corners; you should secure the best coverage possible.
Are bonds the life of the party? Definitely not. But they still play a critical role: They’re like the designated driver that enables people to enjoy the party. And in that way, they’re invaluable.