The creation of ibonds as a new investment class makes it exciting once again to hold cash.
Ask the typical middle-class investor to name an exciting asset class, and he will say “stocks.” Ask him to name a boring asset class, and he will say “cash.”
There was a time when that really was so. Cash really was boring in “the old days.” But no more!
The first reason why the creation of ibonds has made cash an exciting asset class is that this new asset class allows us to make use of the strategic benefits of cash-type investments.
All investment classes have their pros and cons. Cash offers only limited growth potential. If all that mattered in investing were growth potential, cash would rarely hold much widespread appeal.
What makes cash appealing is something different from what makes stocks appealing. Cash doesn’t offer growth, it offers stability.
Most investors are seeking some combination of growth and stability. For many years, the benefits of cash in the stability department were widely understood and appreciated. Cash was never viewed as a good asset class in which to place all of one’s money. But it was viewed as a good place in which to put a portion of one’s assets, the portion for which attaining stability was more important than attaining growth.
That changed when inflation became a persistent reality of the modern-day industrialized economies. It’s one thing to earn a small return from the portion of your portfolio for which your strategic aim is to attain stability rather than growth. It’s something else to lose buying power from that portion of your portfolio because inflation is eating up not only the small return on the investment but something in addition to that.
Cash is not a safe investment in such circumstances. It is a dangerous one. An investment class that offers little upside potential and also offers the potential for significant losses in buying power is an asset class that serves little strategic purpose.
Ibonds are a new kind of cash investment. The return on ibonds is adjusted with changes in inflation, so the investor always earns a positive return from his ibonds. The return on ibonds is truly predictable because the total return is the real return promised at purchase of the ibonds plus the rate of inflation for the time-period over which the ibonds are held.
By purchasing ibonds, you are once again able to tap into the strategic benefits that cash offered in the days before inflation became such an important consideration for investors. Buying ibonds allows you to build a rudder for your investing sailboat that makes the sail provided by your growth-oriented investments that much more effective.
The second reason why the creation of ibonds has made cash an exciting asset class is that the inflation protection offered by ibonds is as effective as the inflation protection offered by stocks.
As the appeal of cash-like investments diminished, investors began to look to stocks for protection from the effects of inflation. It is counterintuitive to look to stocks for safety since stocks are primarily a growth-oriented asset class. But the argument that stocks offer reasonable protection from inflation did indeed make a good bit of sense in the days before the creation of the new ibond investment class.
The idea behind using stocks to protect yourself from the effects of inflation is that, no matter how high inflation goes, businesses still need to earn a profit. So long as companies are able to raise their prices enough both to cover for the effects of inflation and to earn a good profit, shareholders who paid reasonable prices for their stocks obtain some protection from the effects of inflation.
It is an odd strategy to use stocks to protect yourself from inflation. It made sense to do so, however, during the years in which inflation was a serious threat to the financial freedom dreams of middle-class workers and in which ibonds were not yet available for purchase. Say that you are the football coach for a team that has lost its best defensive player to an injury. During the time in which that player is disabled, it might make strategic sense to ask your offense to use plays that allow it to hold onto the ball for longer periods of time, thereby covering for the team’s temporary defensive shortfalls.
With the creation of ibonds, we no longer need to rely on stocks to provide us inflation protection and portfolio stability. Cash has come off the disabled list. We’ve got effective stability-providing cash back!
Couldn’t you continue to use stocks for inflation protection, even now that we’ve got effective stability-providing cash back? You could. The reality, however, is that stocks are not likely to do the job that cash was meant to do as well as cash does it. Now that your best defensive player is off the disabled list, it makes sense to put him in the game.
Some argue that ibonds do not provide effective inflation protection because we cannot count on the government to report inflation accurately. That’s a fair enough observation.
There’s another side to the story, however. If inflation goes up by amounts greater than the government reports indicate, stocks will probably not provide effective inflation-protection either. The argument that stocks can provide effective inflation protection is rooted in showings that stocks have historically provided enough growth to protect those investing in it from inflation. The findings that this is so presume that the government has historically reported the effects of inflation with reasonable accuracy. If we presume that the government will not provide accurate inflation reports on a going-forward basis, then all bets are off. Under that scenario, we cannot count on ibonds or stocks to provide effective inflation protection.
The third reason why the creation of ibonds has made cash an exciting asset class is that stocks have reached levels of overvaluation that make stocks a less attractive long-term bet than they have been at most times in the past.
The historical stock-return data shows that stocks offer an amazing long-term value proposition at times of low valuation, a solid long-term value proposition at times of moderate valuation, and a somewhat iffy long-term value proposition at times of high valuation. The obvious strategic implication is that it makes sense to increase one’s stock allocation at times of low valuation and to decrease it at times of high valuation.
The question that many middle-class investors who understand this critically important reality often ask is — “But what are we to invest in instead of stocks at times when the value proposition offered by stocks is not that great?” Real estate at times offers a fine value proposition, but investing in real estate effectively requires more research than some investors are willing to commit to the investing project. And the returns offered by cash-like investments in the days before the creation of ibonds (and Treasury Inflation-Protected Bonds, or TIPS) were too low and unpredictable for that asset class to offer much appeal as an alternative to stocks.
It’s ibonds to the rescue!
Ibonds and TIPS at times offer very appealing long-term returns indeed. The 30-year safe withdrawal rate (please see the “The Great Safe Withdrawal Rate Debate” section of this site for background) for a portfolio of 80 percent S&P stocks at the top of the recent price bubble was 1.60 percent. The safe withdrawal rate for 30-year TIPS at roughly the same time was 5.85 percent. That’s a dramatic difference in value propositions indeed!
It’s rare to see so dramatic a difference in value propositions between the two asset classes. But I think it is fair to say that the value proposition for ibonds and TIPS has been competitive with the value proposition offered by S&P stocks for a long time now. So long as valuation levels for stocks remain high, ibonds will offer a good choice for the investor seeking to protect a portion of his portfolio from the wild downward price swings typical of the stock asset-class during times of high valuations.
The fourth reason why the creation of ibonds has made cash an exciting asset class is that analytical tools have become available in recent years that permit middle-class investors to make better-informed portfolio-allocation decisions than they ever could before.
Many investors have long intuitively understood that it is a good idea to lower one’s stock allocation at times of high valuations, and thereby avoid the losses often visited on investors who ignore valuation concerns in their financial planning. The hard question to answer has long been — How much should one lower one’s stock allocation, how much should one increase one’s cash position?
We don’t possess a precise answer to that question today. But the Financial Freedom Community has done exciting work in this field in the past four years that has brought us all a lot closer to being able to make portfolio shifts with at least a reasonable amount of confidence that we are doing the right thing. Please consult other articles at the “Valuation-Informed Indexing” section of this site and articles at the “The New Buy-and-Hold” section of this site for reports on the tentative findings from our community’s Great Safe Withdrawal Rate Debate.
The point that is relevant for this article is that many of the strategies discussed in other investing articles published at this site would not be nearly as effective if we did not have available to us ibonds and TIPS. It is the creation of these new and improved cash-type investment options that make it so appealing a strategy to lighten up on stocks when prices are high and to buy more stocks when prices are low.
The fifth reason why the creation of ibonds has made cash an exciting asset class is our discovery of the strategic value of cash-type investments.
“Cash is a strategic investment.”
I remember some time back reading that claim in a post to the Berkshire-Hathaway discussion board at the Motley Fool site, and thinking “that is an insight of great power that has often been overlooked in recent years.”
Cash is not an investment class just for sissies anymore. Cash today is an investment class for the craftiest and highest-return-seeking investors of all, those seeking financial freedom early in life and aiming to wring every last dollar of value out of their earnings to do so.
Putting your money in ibonds is not just a holding action to get you through times when you are too fearful of big price drops to make the sensible choice and invest in stocks for the long term. Investing in ibonds permits you to obtain significantly higher returns from your stock investments than would otherwise be possible.
How so?
First, investing in ibonds protects a portion of your portfolio from big price drops. Say that you have $100,000 invested in stocks and we suffer a 50 percent price drop in coming days. You will have given up $50,000 worth of your precious financial freedom.
It might not sound like all that big a deal to suffer a $50,000 loss. The reality, though, is that even a $50,000 loss is a significant setback. You have heard those claims about how the phenomenon of compounding returns causes a small amount saved today to grow into a far larger sum a few decades down the road, have you not? A $50,000 loss today turns into a significant loss indeed when you count the loss in compounding returns suffered through the years because of a reduction in your portfolio by that amount.
One way to think about it is to see that losing $50,000 in a price drop is like having failed to save the $50,000 in the first place. It takes most of us a good bit of time and effort to save $50,000. We should not try to talk ourselves into believing that losing access to that amount of wealth-generation potential is no big thing. Investing a portion of your portfolio in ibonds can help you protect yourself from the worst effects of big drops in the prices of stocks.
Second, investing in ibonds at times of high valuations permits you to buy more stocks over your investing lifetime than you could have had you put your entire portfolio in stocks.
You often hear stock enthusiasts argue that price drops are not a big concern because price drops make stocks a more appealing long-term investment. “If prices drop, I’ll be buying stocks by the truckload,” they sometimes say.
That makes sense. But how can you increase your stock allocation at times of low stock prices if you invest all of your money in stocks at times of high prices? Investors who invest a portion of their portfolios in ibonds at times of high valuation are far better positioned to take advantage of the bargain prices charged for stocks at times of low valuations.
Another way of saying it is that buying ibonds at times like today allows you to buy more stocks than you could afford to buy today at times when stocks are being offered at better prices. In the long run, the investor who puts ibonds to effective strategic use generally ends up tapping into more of the long-term wealth-generating potential of stocks than does the investor who at all times buys stocks and only stocks, regardless of price considerations.
The sixth reason why the creation of ibonds makes cash an exciting investment class is that the rewards of cash are only now being discovered by middle-class investors.
In January 2000, the value proposition for stocks was at its all-time low and the value proposition for TIPS was near its all-time high. (TIPS are similar in many ways to ibonds, but there are also some important distinctions.)
Does that mean that most middle-class investors were taking money out of stocks and pouring it into TIPS or ibonds? It does not.
Stocks are like a lot of other asset classes in that they are offered at good prices only when there are few determined buyers pushing prices up to sky-high levels. It’s often possible to obtain electronics equipment at a far better price when the novelty has worn off a bit and prices have come down to more reasonable levels. It’s the same with restaurant meals, of course. Those willing to eat at the unpopular “early bird” times can obtain a significantly better value proposition for their spending dollars. When purchasing cars too, you can often get a better price by waiting until the new models are ready to come out and purchasing a suddenly “old” model.
Ibonds are not terribly popular today. The Stocks-for-the-Long-Run Investing Paradigm remains dominant for the time-being. So many middle-class investors are uneasy about the idea of lowering their stock allocations from the levels that they were told were “safe” during the longest and strongest bull market ever experienced in U.S. history. It follows that the returns available from ibonds today are probably a bit better than they will be in days to come, when cash once again becomes the cool investing choice.
You cannot today obtain ibonds providing the sorts of returns that were available only a few years ago. Many middle-class investors have been losing confidence in the Stocks-for-the-Long-Run Investing Paradigm, and so ibonds don’t need to carry such attractive terms to attract sufficient interest. Still, it is possible that even the terms offered today will be viewed as highly appealing after stock prices take a tumble. When stock prices fall, a larger percentage of the investing public will likely come to appreciate the appeal of the stability offered by ibond investing.
Ibonds are strategic. Ibonds are cool. Ibonds are cash, new and improved!