Cash can make you happy, at least according to an article from the Wall Street Journal titled “Money and Happiness: A Surprising Twist,” published last year. The article cites a study by a team of researchers from the University of California at Riverside and the University of Cambridge in the U.K. that focused on bank account balances. While plenty of academic studies have explored the relationship between one’s income and happiness or one’s level of consumption and happiness, few have studied the impact of cash on a person’s happiness. This study did just that, and it shows there is a correlation between bank account balances and life satisfaction. The idea that cash brings additional life satisfaction, even controlling for things like income levels and net worth, will certainly inspire more research of this kind. For now, it helps explain why some investors keep so much of it. Cash is not just a way to avoid investment risk; it can help make you happy.
Unfortunately, creating happiness is not as simple as holding hoards of cash. The more cash you have, the more muted its effect becomes. For example, increasing a bank account balance from $100 to $1,000 has a larger impact on life satisfaction than increasing the balance from $1,000 to $10,000. And at some point, piling more cash into the bank does nothing to boost happiness. There is also the matter of inflation, which has a famously erosive effect on cash.
Impact of Inflation
While year-over-year inflation has remained tame at around 2%, it will rise at some point. But even if it doesn’t, the return offered on cash in banks still falls below even this modest inflation rate. In many years, the impact of inflation is subtle, but over time the incremental erosion becomes dramatic. There are very important strategic reasons to keep emergency cash reserves. But those with excess cash reserves should consider investing in bonds. Bonds help fend off the effects of inflation through a steady stream of interest payments. And although bonds lose value in some years, the losses are much tamer than what investors experience in the global stock market. The chart below shows the last three calendar years in which the global stock market lost value.
|MSCI All Country World Index:
last three years in which the global stock market lost value
Compare that to the last three calendar years in which the U.S. bond market lost value.
|Bloomberg Barclays Capital U.S. Aggregate Bond Index:
last three years in which the U.S. bond market lost value
Bond Indicies Reduce Risk
The Bloomberg Barclays Capital U.S. Aggregate Bond Index is a well-known representation of the U.S. bond market. Indices such as the Bloomberg Barclays can be a useful way to diversify away the risk of individual bonds. With individual bonds, there is always the risk that the issuing entity will become insolvent. In these cases, the individual bond can default and lose some or all of its value. Indices reduce this risk by holding hundreds of -individuals bonds so that no single bond dramatically spoils results. And while we like the diversification of bond indices, there are even better ways to diversify away the risk of individual bonds.
Indices tend to work best when the universe of investments is constrained. The U.S. stock market is a good example. The number of stocks listed on the U.S. stock exchange peaked at the height of the tech boom at around 6,000. With the disappearance of many of those tech companies and other companies consolidating through mergers and acquisitions, the number of stocks listed on the U.S. stock exchange currently sits around 3,500. That is a relatively constrained investment universe.
Unlike the stock market, the bond universe is in a constant state of formation. Every month, billions of dollars of bonds are created, and billions of dollars of bonds reach maturity. It can be a real challenge for a bond index to incorporate these ongoing changes. So the indices rely on the work of the three major rating agencies: Moody’s, Standard and Poor’s, and Fitch. As bond specialist Carl Pappo put it: “Not until a bond issue is warranted ‘investment grade’ by two of the three major agencies will the Barclays Capital U.S. Aggregate Index agree to admit it to listing.”
The work of these rating agencies, though, is not always timely. Take bonds from Puerto Rico for example. After being deemed investment grade by the rating agencies, the price of Puerto Rican long-term bonds peaked around May of 2013. It wasn’t until February of 2014 that agencies changed the ratings of these bonds from investment grade to junk, thereby expelling the bonds from the Bloomberg Barclays index. The expulsion, unfortunately, came after their price had fallen by 31%.
Another problem with bond indices is that they are weighted by capitalization. The article “Read the Footnotes,” published in Grant’s Interest Rate Observer, explains the problem of capitalization-weighted bond indices. The more bonds a borrower issues, the more of those bonds the bond indexer is obligated to buy. Yet the more bonds a borrower issues, the less creditworthy it becomes, all other things being equal. In essence, bond indices require investors to own more and more debt of companies and countries whose situations are becoming more and more precarious.
Actively-managed bond mutual funds, on the other hand, do not have to wait for the pronouncement of rating agencies to decide which individual bonds to hold. They can act on their own analysis and focus on the parts of the bond universe where bonds look most reliable. Government and corporate bonds tend to dominate bond indices, but active bond managers can focus on any of the bonds in the bond universe including municipal bonds, mortgage-related bonds and foreign bonds, all of which improve diversification.
Have a Plan
Before investing in bond funds, it is important to have a thoughtful plan about cash. Every investor should have an emergency cash reserve in the bank, and it is worth doing the work to determine what that amount of cash should be. But for investors with excess cash reserves, bonds can be more than ballast to a portfolio during stock market corrections or crashes. In the last three decades, bonds have not underperformed cash for more than three consecutive years. With time on your side, they are a better way to keep up with inflation. Cash makes people happy but preserving purchasing power does too.