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Do I really have to buy bonds?

We get that question a lot. The argument goes something like this:

Interest rates are low. Sooner or later, they will rise. Right now, it looks like sooner. When interest rates rise, bond prices fall. Do I really need to own something which will probably go down?

My take:

If there’s a good chance you will need to withdraw some of your investment over the next decade, own something that cannot lose a lot of value just when you need the money. Stocks don’t work. For example, stocks went down 50% in one year during the 2007-09 crisis.

Real estate doesn’t work. You cannot sell quickly, at least not at a fair price.

A line of credit (borrowing) also does not work, unless you can pay it back in a year or so.

So, your choices are cash or bonds. Here is where the argument gets interesting.

The good thing about cash is it never loses nominal value. The bad thing about cash is that, over the long-term, it will always lose real value, due to inflation.

Some people hold cash to cover expenses over the next year or so. That makes a lot of sense.

Some people hold cash because they are betting bond prices will go down, and they’re waiting to buy bonds after the fall. I believe that makes less sense. Sure, you may get it right. But the odds are against you. On average, bonds generate a higher return than cash. Betting against the market is hard, because the price of bonds at any moment represents the collective wisdom of trillions of dollars.

My suggestion:

For your cushion, keep enough in cash to cover expenses for 3-6 months if you’re employed, and a year or so if you’re retired. The rest of your cushion should be in bonds. Over years, bonds will, on average, beat cash. They won’t beat stock, but they’re not supposed to. You own them for protection.

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