Everyone needs to keep some cash on hand for bills and emergencies. But cash held in bank savings accounts can also help reduce the volatility of an investment portfolio, and it can provide a reserve for jumping on investment opportunities.
So how much of this type of cash should you have?
A key issue in deciding is the amount of risk in bonds and bond funds, which come next to cash in the stocks-bonds-cash hierarchy of risks versus returns.
Bonds are not as risky as stocks but they are riskier than cash, and the degree of risk rises and falls with market conditions. In periods when bonds are riskier, it can make sense to switch some money from bond holdings to safe bank savings like certificates of deposit.
While bonds involve various types of risks, one of the most important is “interest-rate risk,” the danger that an older bond’s value will fall if newer bonds offer higher yields.
After all, no one would give you the full $1,000 face value of an old bond yielding 5% if a new bond paying 10% could be bought for the same price. In this simplified example, your old bond’s value would fall to $500, so its annual $50 coupon would equal the 10% yield offered by new bonds.
In the real world, it’s much more complicated than that. A bond with 10 years to mature would be hit much harder by a rise in interest rates than one with a two-year maturity because the owner of the long-term bond would be stuck with the below-market yield for so much longer.
To provide an easy measure of interest-rate risk, bond experts have devised a measure called “duration,” which is expressed as a number of years. A longer duration means bonds and bond mutual funds are riskier. A 10-year duration means a bond would lose about 10% of its value if interest rates rose by 1%, while a bond with a two-year duration would lose just 2%.