Should You Invest in Stocks, Bonds, or a 5% CD?

Key Takeaways

• In terms of the pros, yields are certainly compelling. Another one is safety, in that we’ve seen significant principal-related losses for some bond investors over the past couple of years.
• In terms of the disadvantages, one of the key ones is that these yields are ephemeral. The high yields on offer today may not be available in the future.
• For bonds, you are able to lock in a higher yield for longer. For stocks, you have the best long-range opportunity to outrun inflation.
• We found that thanks to the higher yields for cash and fixed-income investments today, the Monte Carlo simulations heavily favored a portfolio with a fairly significant stake in fixed income. So, the highest safe withdrawal rate corresponds with a portfolio that’s between 20% and 40% in equities.

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. With cash and bond yields at their highest levels in about 15 years, many investors are wondering whether they should be favoring these higher-yielding options over stocks. Joining me to discuss how to approach asset allocation in an era of 5% CD yields is Christine Benz. Christine is Morningstar’s director of personal finance and retirement planning. Great to see you, Christine.

Christine Benz: Hi, Susan. Great to see you.

Why Should Investors Avoid Overallocation to Cash?

Dziubinski: Investors and advisors have really demonstrated quite the appetite for various cash instruments, especially as yields have been rising. What are the key pros and cons to be thinking about with cash holdings today, and why is it maybe not the best idea to overallocate to cash right now?

Benz: As you mentioned in terms of the pros, the yields are certainly compelling. In many cases, the yields are better than what you can get on certain bonds and bond funds today. That’s an obvious attraction. The other one is safety, in that we’ve seen significant principal-related losses for some bond investors over the past couple of years. Well, if you’re a cash investor, you do not have that volatility in terms of your principal value. That’s another key attraction. Liquidity may also be an attraction, and that goes hand in hand with the idea that you have safety and principal stability. Many money market funds, for example, and other bank savings accounts offer you ready access to your funds. Some might even give you checks that you can write from. So those are some of the key benefits. In terms of the disadvantages, one of the key ones is just that these yields are ephemeral, that the high yields on offer today may not be available in the future.

Certainly, if you lock in a longer-term CD, you’ll be able to have that high yield longer. But if you’re in some sort of a money market mutual fund, for example, well, your yield is going to fluctuate based on whatever the prevailing interest-rate environment is. Another consideration is inflation risk, that when we look at cash yields over very long periods of time, they sometimes beat inflation but not always. And that’s I think, top of mind for all of us as we’ve had very high inflation recently. So, that would be the shortlist of disadvantages. The reasons not to overallocate to cash investments today.

Advantages of Bonds Over Cash

Dziubinski: Given where cash yields are, what is the case for bonds right now? Given that, again, if I can get a 5% yield on a cash account, I’m not risking any principal.

Benz: Well, a couple of key advantages. One is that you are able to lock in a higher yield for longer. So, if you buy, say a five-year bond or a 10-year bond, that means that interest rate will prevail over your holding period. That is one, and another is you do have some appreciation potential with fixed-income instruments, which is something you do not have with cash instruments. You don’t have principal volatility, but that goes both ways. You can’t have losses, but you can’t have gains, either. And so those would be the key advantages that I would say would go along with investing in fixed income. Especially as we think of potentially rates going lower in the future, the fixed-income investor stands to benefit potentially from some appreciation in such an environment.

Advantages of Stocks Over Cash

Dziubinski: What about stocks?

Benz: Stocks of course have unlimited upside potential. When we look at the asset classes that have had the best long-range opportunity to outrun inflation, while stocks have certainly done that, and then some. That would be the main advantage for stocks. The main disadvantage, of course, is significant principal volatility potential. So when we look at the standard deviation on a total market equity fund, which is a pretty well-diversified equity fund, it’s like 3 times what you might have on a total bond market index. So, you need to be prepared for significant principal-related volatility.

How Should Investors Divide Their Assets?

Dziubinski: How would you suggest that investors approach these decisions about how to divide their assets over these three main asset classes right now—cash, bonds, and stocks?

Benz: I would put my proximity to needing my money front and center in the decision-making process. We’ve recently rolled out this great Role in Portfolio framework that I think is really helpful for matching various investment types to your time horizon. I typically think of cash investments as being appropriate if you have a very short-term time horizon for your funds. So maybe a couple of years, and then you expect to need your money or you need your ongoing liquidity. And then maybe another two to six years, or I would say even two to 10 years for fixed-income holding seems appropriate. And then if you have a time horizon of say, six to 10 years or beyond, then I think equities are a fairly reasonable bet. So, I would think of proximity to using my money as maybe the main consideration or definitely the main consideration.

And then I think a little bit about my personal attitude toward risks and fluctuations in my portfolio. If I am someone like me, I have a lot of tolerance for the principal-related volatility, but I’m not retired. Other people have much less appetite for some of that volatility. So, you want to think through those things. And then also just think about how well-situated is your plan. If you have a tighter plan, unfortunately, that argues for taking a little bit more risk with your portfolio. If you have, I would say a more flesh plan where you have more assets, there’s more margin for error, and more margin for some of these peace-of-mind type investments, I think you can allocate a little bit more to the safe stuff.

Withdrawal Rates for Different Asset Allocations

Dziubinski: Christine, you and some of your colleagues are working on a research paper about withdrawal rates in retirement for various different asset allocations. What did you find?

Benz: Well it was interesting, Susan, because we do this retirement spending research every year, and we revisit it annually. And we have this base case where we assume that someone wants a fixed real paycheck for 30 years of retirement. And what we found was that thanks to higher yields that are available for cash and fixed-income investments today, the Monte Carlo simulations that we run heavily favored a portfolio with a fairly significant stake in fixed income. So, the highest safe withdrawal rate actually corresponds with a portfolio between 20% and 40% in equities.

Which is a lot lower, I think, than many retirees approach their retirement plans. And so I think it’s worth pointing out that we’re making conservative assumptions about the spending plan. Most retirees are willing to tolerate some fluctuations in their spending from year to year based on how their portfolio behaves. So, there are some assumptions that we make that are pretty conservative, that tends to bias our model toward a fairly conservative asset allocation. But nonetheless, I think food for thought, if you’re a retiree and you’re someone who has a 90% equity weighting, we’ll step back and think about whether you can potentially achieve your goals with a less risky portfolio.

Which Type of Retiree Should Own More Stocks?

Dziubinski: And then lastly Christine, what type of retiree might want to stick with, say, a more heavy stock-focused allocation in retirement?

Benz: Well, a couple of profiles I think this would be appropriate for. One would be the retiree who is willing to make course corrections in his or her spending. In that case, then a more equity-heavy portfolio mix might be appropriate. And the other thing is, there’s a relationship with ending portfolio balances, that at the end of 30 years, we look at, well, what’s left over for heirs or charity or whatever the case might be? What we find is that the more equity-heavy portfolio mixes do tend to have those higher residual balances. So, if that’s your goal to have leftovers at the end of your retirement lifecycle, having a little more in equities, at least a little more, will tend to favor the ability to make those dispositions at the end of your life.

Dziubinski: Got it. Well, Christine, thank you for your time today. We’re in a very interesting interest-rate environment right now, so we appreciate your insights.

Benz: Thank you so much, Susan.

Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks for tuning in.

Watch “How to Manage Capital Gains Distributions From Your Funds in 2023″ for more from Christine Benz.