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Welcome back. Today’s episode was sparked by questions from people on my book updates email list for The Perfect Portfolio.
Quick clarification: those book updates go out every other Saturday. They’re separate from my regular newsletter, which comes out every Wednesday with my latest content and links to the most important articles and resources I’m reading.
If you want the book updates, you can sign up using the link at the top of this episode description in your podcast app—or you can visit theperfectportfoliobook.com.
When you join that list, you eventually get a peek at the book’s outline—and I invite you to reply with your thoughts and questions. What caught me by surprise is how many replies were about bonds.
Bonds are the topic where smart people feel unnecessarily confused. In many ways, they seem less intuitive than stocks, and most of the industry explanations don’t help.
See: The Problem With Investing in Bond Indexes and Bond Funds vs Individual Bonds
But in a subscriber-only webinar, I had this “wait… that’s what you’re asking” moment.
A lot of the emails weren’t really about bonds in the portfolio. They were about bond ladders and what I would think of as cash management questions.
Not: “What should my long-term bond allocation be?”
More like:
- “How do I avoid selling stocks in a downturn?”
- ”How do I keep my plan intact if markets are ugly?”
- “How do I invest money that isn’t needed in the next year or two, but that I don’t want susceptible to market swings?”
- “If you don’t like individual bonds… what does that mean for my bond ladder?”
So that’s what we’re doing today. We’re not doing a bond primer. We’re talking about designing a cash management system that lives outside of your portfolio and is separate from your long-term bond allocation.
Sign up for my newsletter so you can easily reply to my emails with your thoughts or questions for the podcast:
Investing vs. Cash Management
The reason we invest money is to grow our savings at a rate greater than inflation without taking undue risk.
But because investing comes with volatility that is the cost of returns that exceed inflation, you shouldn’t have savings invested that are needed in the near-term. Investing is for money you can leave alone long enough for the volatility to be worth it.
Cash is money that has to work on your schedule and not the market’s. It should not be expected to generate a return that outpaces inflation. In fact, after-tax, real returns on cash have historically been negative.
So during your working years, cash is typically set aside for things like:
- Tuition, taxes, or a known big bill
- A down payment or planned remodel
- The “life happens” stuff—roof leak, car repair, big medical bill, job loss, etc.
When you’re near retirement or in retirement, perhaps you’re holding cash for similar reasons, but my experience is that it’s primarily for the next 12 to 24 months of retirement withdrawals.
The cost of cash is that your after-tax, real returns are negative. So I’m typically hesitant to insure against more than two years of price fluctuations.
When you look at historical S&P 500 bear markets, the average “round trip”—from the prior peak, down to the low, and back to the old high—has been roughly two and a half years. According to LPL, bear markets last longer during recessions (43 months) and shorter when there isn’t a recession (16 months).
If we look at bear markets in the S&P 500, we see that the average time it takes for a bear market cycle is 2.5 years. According to LPL, the average during a recession is a bit longer (43 months) compared to a no-recession bear market (16 months).
In my mind, holding two years of cash allows you to avoid the worst version of forced selling—selling during the decline. Historically it’s taken the S&P 500 11 months to bottom out, so if you need to tap your portfolio before the market has returned to the previous high, you’re more likely doing it during stabilization or recovery, not during the freefall.
And yes—there are outliers (1972-1973 and 2000-2002) where it took many years to reclaim the prior highs. But even in those longer cycles, one to two years of cash can still do its job: it reduces the odds that you’re selling stocks while the market is still sliding.
Because the nightmare scenario for retirees usually isn’t, “the market went down.”
It’s, “the market went down—and I had to sell into it to pay bills.”
That’s the trap the cash bucket helps you avoid.
Could you keep more than two years in cash? Absolutely. For some people—especially if spending is inflexible, or you just know you’ll sleep better—that can be a perfectly reasonable choice.
Just be aware of the tradeoff: more cash buys comfort at the cost of inflation and missed compounding.
Why Bond Ladders Feel Safe (and the Risks They Quietly Add)
If you want a second layer that pays a little more than cash, this is where people often reach for bond ladders.
The appeal of bond ladders is certainty and control. You can point to maturity dates. You can tell yourself, “I get my principal back at maturity.” And you can avoid seeing daily price fluctuations the way you do with a bond fund—so it feels calmer.
That emotional comfort is real. But it doesn’t eliminate risk. It changes the kind of risk you’re taking.
For starters, using individual bonds is simply inefficient relative to using bond funds — it’s really not a debate. I’ve covered this topic multiple times over the years, but most recently in EP.223 if you want to scroll back to understand why this is true.
The short version is they are more costly (no they’re not free), less diversified, and carry meaningful reinvestment risk. A longer, more nuanced version will also point out that you’re leaving a lot of return on the table (without a meaningful increase in risk) by using individual bonds.
So if you have this second layer of protection against a downturn that lives outside of your long-term portfolio, my preference is to use an ultra-short or short-term bond fund—it’s simpler operationally, it reinvests continuously, and it adapts more efficiently as yields change.
If you want me to go deeper into some aspect of this topic that isn’t covered in EP.233, then drop me a note either by replying to one of my emails or visiting thelongterminvestor.com
Building a Cash Management Plan: The 3-Bucket Framework (Years 1-2, Years 3-5, Everything Else)
So how should we think about cash management?
I find it useful to think of your cash in a separate “bucket” from your long-term portfolio.
Bucket #1: Cash For Expenses in Years 1 and 2
During your working years, the opportunity costs of missed compounding seem too high to having more than one year’s worth of expenses in cash.
For retirees, one or two years of cash seems like a reasonable amount that balances the opportunity costs of higher compounded returns with the insurance against selling investments during a bear market to meet living expenses.
Cash should be kept in an online savings account or a money market fund that is liquid, predictable, and no surprises.
When it comes to refilling the cash bucket, I’d suggest that you look at your target—say 12 to 24 months of spending in cash—annually as part of a year-end planning process.
If you’re above target, great—leave it alone. If you’re below target, refill it as part of your normal portfolio maintenance—often by trimming what’s up the most.
If you’re in a bear market and want to allow your portfolio time to recover, then don’t refill your cash bucket.
Here’s the bonus behavior I let people get away with: If your financial plan is in solid condition and you want to refill your cash bucket during a downturn in hopes of avoiding more losses—this is the one time I’ll shrug my shoulders at an attempt to time the market. It’s the sort of behavioral allowance that acknowledges we aren’t all robots and it’s typically not going to noticeably impact a financial plan that is in solid shape.
(Optional) Bucket #2: Savings For Expenses in Years 3-5
If you want a second layer of protection against a prolonged downturn that pays a little more than cash, this is where people often reach for bond ladders.
To be clear, I don’t think this bucket is optimal or necessary, but if you can afford to pay for more insurance against market volatility in the form of lower returns, my preference is going to be using ultra-short or short-term bond funds rather than a bond ladder.
When you have this type of bucket, you’ll want to make sure that interest payments are automatically invested into the fund and that it’s the first source of funding the refill of your cash bucket.
Now before you get nervous about potential price declines in a bond fund, I’m going to make this really simply rather than do a deep dive:
If your holding period is longer than the duration of the fund, any increase in interest rates will enhance your returns relative to owning individual bonds. And if rates fall, then
Bucket #3: Everything Else
The rest of your savings should be invested in a long-term portfolio with a mix of stocks and bonds that is aligned with your risk tolerance.
The use of bonds in this bucket is to reduce the overall volatility you experience. The more bonds you use, the lower your expected returns. Deciding how much you should have in bonds is what we will be discussing next week, so be sure to tune in.
If you found this episode useful, please consider leaving a review in your podcast app—it helps the show grow and let’s more people find information to help them make good decisions with their money.
Thanks for listening.
Resources:
- EP 99: The Problem With Investing In Bond Indexes
- EP 223: Bond Funds vs Individual Bonds: What’s Best for Your Portfolio?
- S&P 500 Teetering on the Edge of a Bear Market (LPL)
The Long Term Investor audio is edited by the team at The Podcast Consultant
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