 Personal Finance PowerPoint Presentation – Cash vs. Bonds – Prepare to get financially fit by practicing personal finance. Most of this information comes from Investopedia – Cash vs. Bonds – What's the Difference which we can find online. Take a look at the references, resources, continue your research from there. This is by Claire Boyd White, updated August 31, 2020. In prior presentations, we've been taking a look at investment goals, investment strategies, investment tools, keeping those in mind. We're now looking at Cash vs. Bonds – Noting this was written in 2020, but the concept of Cash vs. Bonds will be relevant just in theory as we go through different market changes in the market. So with the bold market and the U.S. economy now over 10 years old and talk of a pullback, many are more concerned with protecting the money they have than with growing additional wealth. So you can see basically the sentiment of the market oftentimes as for example you're in a period of extended growth period, then towards the end of that you might be thinking okay there's got to be a pullback here at some point in time or you could have different sentiments of course if you're in a period where there's been a downturn in the market you're thinking well there's got to be a point at which this is going to turn around and those are going to have impacts on your investment decisions although we also want to be considering the fact that many investors are individual investors looking for the long term investment strategies so we may not be as good as individual investors to be determining how long the bold market or the bear market is going to be running and using diversification over a long run in order to help safeguard ourselves. So there are a number of investment vehicles touted as quote safe in quote places to store savings but many people feel nothing could ever be as safe as cash so often times people think that just having the money in the bank would be the you know the safest place to be although of course if it's just in the bank then you're probably making little to no earnings or return on it and it's going to be eaten away with inflation to some degree although it's not going to be eaten away as fast as if you run into a bear market and you have your money in the stock market that could decline in value so the security of knowing exactly where your money is such as safely stowed away in a federally insured checking or saving account is undoubtedly appealing the fact that it is federally insured often times up to a certain extent that can be a benefit clearly as well however with the risk of inflation potentially rendering today's dollar significantly less valuable down the road many low risk moderate reward investments continue to be popular among investors looking to put their money to work without incurring too much risk so clearly if you especially if you think of course the markets going down if you're trying to gauge the market often times people are going to possibly pull money out of the equities try to find some other place to put them that hopefully can at least be pulling in enough for inflation right but even if you don't then you're thinking well at least it's not going to be you know hit really hard in a recession or if the equities go down as it might be in the stock market so then bonds for example might be a place to go so bonds in particular have long been heralded as one of the safest investments available because they guarantee the return of principal while still generating periodic interest payments so we've talked about different classes of bonds but obviously the big one that people think about would be the US bonds because there's little risk of default risk there and you can still possibly get some investment return so most of the time when we're thinking about our diversified portfolio we've got the money possibly in the cat in the in the stock market to some degree possibly saving under the umbrella of a retirement account like a 401k or an IRA and then we've got the other safe hedges against against the volatility of those investments possibly in say cash CDs savings accounts and bonds usually bonds in that instance looking towards the more kind of secure bonds possibly government bonds or or very secure corporate bonds so holding cash and investing in bonds are both viable options for those looking to protect their savings from a volatile market one that could fluctuate up and down however it is important to understand the risk and rewards of both options to ensure you choose the investment strategy that best suits your needs cash the primary benefit of keeping your money in cash is the obvious advantage of maintaining complete control meaning you could take the money out at any given time if you have cash flow needs that are immediate and upcoming and then it's nice to have your money in a check account right if you simply deposit your cash into a bank or savings account you can easily review your balance and transaction history with a click of a button knowing that no one but you has accessed those funds so it's usually an online banking you can check it out online fairly you know fairly easily in addition checking and saving accounts at almost any bank are insured through the federal deposit corporate insurance corporation the FDIC up to 250,000 so that is a concept that was put into place so that when you think about the bank when you put the money in the bank they're not actually holding on to your money they're holding on to a reserve of portion of the money and then they're investing the money that's how they make money that means that if there was a run on the bank everybody go into the bank losing trust in the bank wanting their money at that point in time the bank wouldn't have it because they've invested a lot of it and it's not fully liquid to be giving back at that point in order to stop the bank runs you've got this FDIC insurance which is it's supposed to give more security and does and so that could be a significant impact giving us more security in our bank deposits well banks are not required to purchase this coverage it has become such a ubiquitous symbol of a bank's quality that any institution that is not FDIC insured is not likely to do well so you want to make sure that the bank you are at is FDIC insured most of the big banks will be because if they weren't they probably wouldn't do that well at this point in time so accounts of federal and state chartered credit unions are also issued up to 250,000 through the National Credit Union administration the NCUA even if your savings exceed this limit it is possible to ensure all your deposits by opening multiple accounts at different institutions so you might say well what if I have more that I need to invest the 250,000 then you might think about investing them if you want them and like a checking account in multiple institutions so you still have that coverage because now you're at multiple institutions that have that cap at the 250,000 so another advantage of keeping cash is it provides ultimate flexibility in times of stress if you need to access your funds in the near future such as it as within the next three years holding cash is the best way to ensure that you have the money whatever you need it so if you need the cash if you got cash flow needs coming up that are going to be applicable then clearly a checking account would be nice in that case though investing offers the possibility for profits it can also put your funds at significant risk maybe you may not have the money you need on the short notice so when we think about the kinds of risks that could happen in the future we have investment risk meaning risk that the investment is going to increase or decrease in value differences between stocks CDs bonds and so on and also if we're locking our money away in some way even if it's in a savings account we may reduce the risk of the amount going down the principal going down but if we have cash flow problems and our money is locked away we have that risk that we want to take into consideration as well risk of cash the biggest risk you incur when holding cash is the risk of inflation if interest rates rise the money you have now may have significantly less buying power in the future so if you've got money just in the checking account and there is inflation then that money you're having the checking account you're probably getting a very low if any rate of interest on it and therefore you're losing purchasing power as it's in the checking account again that's bad but it's not as bad as if you were for example in the stock market in the point of a bear market or recession because then the stock market would go down the principal could go down in that instance as well so then this is the main reason that most investors allocate much of their cash holdings to cash equivalent money market accounts or mutual funds so though these types of highly liquid investments generate only a modest amount of interest it can be enough to offset the effects of inflation over time so if we have a significant amount of cash to basically cover our short term needs then we might want to put them into an account that's going to give us a more more return again we might put it into something like like stocks or equities for example but if we're if we want to have a portion of that more secure or have a fixed return on it then we might put it in some other format of a cash account like a CD or savings account or something like that and get some rate of return not the potential return that we could get on the stock market most likely but we're not exposed to that volatility of the stock market either so the other disadvantage of holding cash is it carries a significant opportunity cost opportunity cost refers to the forfeiture of potential profits that could have been generated had you used your money in a different way since holding cash if effectively generates zero profit the opportunity cost of this strategy can be quite high so in other words if you've got a lot of money in the checking account you don't need it for your current cash needs you're in essence investing it if you were to invest it in like the stock market for example you have the potential to have higher returns so opportunity cost is basically an economic term which means that any choice you make has a cost there's nothing that's cost free in the world of economy because anything that you choose means that you chose not to do something else so if you choose to have money into the checking account you're losing the next best option that you that in your thought process would possibly be you could have had it in a in stocks for example and if the stocks did well then you're losing out on the gains you could have got on the stock market but again you want to think about it in terms of your overall portfolio with your overall risk management strategy applied so this is known as cash drag in a portfolio so in portfolio terms cash drag note that if you're talking to investors oftentimes you they might be more aggressive right because they want to put the cash to work somewhere in some way some form and and possibly be an over-aggressive to some degree because that you know investing in whatever their preferred investment is is possibly more than what they do so so don't let them convince you that you don't want anything in less risky areas like CDs possibly cash or possibly bonds and what not but just know in terms of portfolio terms then they call that the cash track right you got this money in cash it's not making you money on that in there so given all the different investments available that generate guaranteed income such as bonds and certificates of deposit CDs holding cash means you might be giving up the opportunity to reach to reap significant returns bonds unlike holding cash investing in bonds offers the benefit of consistent investment income so bonds as we've discussed in prior presentations are in essence like loaning money to the issuer of the bond usually we first think about for example the government because it's a good baseline ruler because there's usually going to be no or very little default risk because of the ability to tax and basically print money at least on the US federal government level type of things and we can also get bonds then from the from corporations and we might use tools such as ETFs and mutual funds to get exposure to bonds which are more fixed income type of tools so bonds are our debt instruments issued by governments and corporations that guarantee a set amount of interest each year investing in bonds is tantamount to making a loan in the amount of the bond to the issuing entity in exchange for this loan that the issuing company or government pays the bondholder monthly quarterly semi-annual or annual coupon payments equal to a set percentage of the bonds par value so in other words you're kind of like loaning them money they're gonna give you the money back at the maturity in essence they're also going to give you in essence rent on the money no one has interest similar to if you were to basically rent out an apartment for example you would expect the apartment to be returned at the end of the agreement and have the rental income for the use of it with bonds the rental income for the use of the money that you that they're borrowing is in essence the interest the income generated by bond investments is stable and predictable making them popular investments for those looking to generate regular income once a bond matures the issuing entity pays the bondholder the par value of the bond regardless of its original purchase price so we won't get into the difference on the purchase price but because it could vary especially on the secondary market so investing in bonds offers the potential for capital gains if a bond is purchased at a discount as well as interest income so bond risk bonds carry a varying degree of risk depending on their maturities which can range from a few months to several decades and the credit rating of the issuing entity investors can choose which type of bonds to invest in based on their goals and risk tolerance so when we're investing in bonds we're usually kind of trying to balance our portfolio against possibly stock investments which have more volatility on the stock side in that case oftentimes we're looking for the for the safer bonds the less risk bonds possibly government bonds and secure basically corporate bonds bonds having the risk of default one risk which would be basically the issuer goes out of business and isn't able to pay the bonds for example not likely to happen for us government bonds we hope more likely to happen for small corporation bonds and then the other risk is that basically the market inflation rate changes or interest rates change on the market in relation to the bond rate that we have secured when we purchase the bond so in times of economic instability bonds and other debt instruments issued by the US Treasury are considered extremely safe because the risk of US government defaulting on its financial obligations is amenable so when you talk look at like stock market channels and that kind of stuff when people start to run to bonds and start investing in bonds it's usually people getting panic either saying well why are people doing that possibly they think the stock market's going to go down equities are not going to have the gains they're going to they're going to decrease and therefore people are running to the safe havens of the bonds so but obviously we may not be able to judge that particularly as an individual investors when the market's going to go up and down we might be looking at that long-term strategy trying to find a good balance between stocks bonds cds cash and and then play the long game on it instead of trying to beat the market on the day-to-day the whims because we as individual investors are more likely to just to not have the relevant information as fast as other people and possibly be paying more attention or making more decisions emotionally based rather than rather than with the full data therefore more likely to not not gauge the market therefore the long term strategy is often good for us it's often good for the professional investors as well as unless they have some insider information or something so similarly bonds issued by very highly rated us corporations are typically very low risk investments for of course the interest rate paid on these high quality bonds are often lower than those paid on junk bonds or other risky investments but their stability may be worth the trade-off so when we're thinking about bonds if you have zero default risk or very low default risk with government bonds and a corporation wants funding from us then they're going to have us give us a bigger return so we will demand a bigger return on the market because there's more risk related to the corporate bond for smaller corporations that have much higher default risk than the government or large corporations then of course we're going to want more of a return on them so in addition bonds issued by the state and the local governments are typically not subject to federal income tax making them one of the more tax efficient investments available key differences the biggest difference between bonds and cash are the bonds or investments while cash is simply money itself cash therefore is prone to loss to to lose its buying power due to inflation but is also a zero risk of losing its nominal value and is the most liquid asset there is so bonds you could think of as an actual investment kind of tool cash i guess you can basically think of as just basically cash in the bank the cash in the bank has low risk in that you don't you don't expect to lose the cash especially since it's insured but because you're not getting interest on it then you you're going to be losing some you would think due to inflation although again you're not you're not subject to basically the flexibility or the flexibility or risk volatility of the market in terms of equity markets so much so the primary risk of bond investing is your investment loses loses value if an issuing entity defaults you may lose some of your investments so if you invest in bonds and the like junk bonds or something like that then the issuer may default on the bonds not pay back the bonds and that would be not good you would lose value there but if you invest in government bonds that's less likely to happen while bondholders have a higher claim on company assets than stockholders the likelihood of receiving the full value of your bond after a company declares a bankruptcy is low since it likely it must first pay off the loans mortgages and other debts so if they did liquidate then meaning they went out of business went into bankruptcy you get paid before the stockholders in that case but you still may not get the full payment because they got to pay off all their other liabilities first so your bond may also lose value if rising interest rates render it worthless on the secondary market so if new bonds are issued with higher coupon rates the market value of your bond declines so that could be called like interest rate risk because if we have locked in rates of returns on the bonds those rates will typically be of course higher than they would have been if we just had the money in the checking account so we still might be like better off than in the checking account but if we had the money at that point then we could we could purchase other bonds at that time at the higher rates as the market rates are going up however this is only a concern if you are looking to trade your bond before maturity so clearly you know if you have the bonds also you could trade them on the secondary market in other words the primary market means that you purchase the bonds directly from the issuer the government or the corporation then you can trade them on the secondary market again you might get exposure also to the bonds using mutual funds or ETFs those being items or investments that you may also be able to trade as well so if you retain your bond until it matures you are paid its par value regardless of its current market price unlike keeping your money in a checking or savings account any investment in bonds is uninsured so that's a detriment you don't have that same kind of FDIC insurance just like stocks or mutual funds you voluntarily take a certain degree of risk when you purchase bonds because of this the FDIC does not ensure these investments if you lose money on bond investments there's no way to recoup your losses however you can largely mitigate this risk by investing in highly rated bonds and holding them until maturity