Stocks, Bonds, and Cash: What Each Is For

If stocks have tended to grow more than bonds or cash over long stretches, why would anyone hold anything else? The answer is that these three assets are not competing for the same job. Each represents something different, behaves differently, and suits a different span of time.

A stock is a share of ownership

When you buy a share of stock, you own a small piece of a business. That share entitles you to a portion of whatever the company earns, either paid out as dividends (cash distributions to shareholders) or reinvested in the business to make it more valuable over time.

Because ownership has no fixed payoff, a stock's value depends on how the business performs and on what other investors are willing to pay for it. That is the source of both its appeal and its discomfort. Over long periods, the growth of businesses has historically been the main engine of investment returns. Over short periods, prices can swing widely for reasons that have little to do with any one company.

Stocks as a group are often called equities. They are the part of a plan that is asked to grow.

A bond is a loan

When you buy a bond, you are lending money to a government, a company or another borrower. In return, the borrower promises to pay interest on a schedule and to return the original amount, called the principal, on a set date known as maturity.

That promise is what makes bonds different. A bondholder does not share in a company's success beyond the agreed interest, but also stands ahead of shareholders if the borrower runs into trouble. The result is a narrower range of outcomes: less upside than stocks, and usually less downside.

Bonds still carry risk. A borrower may fail to pay, which is called credit risk. Bond prices also move opposite to interest rates: when rates rise, existing bonds paying lower rates become less attractive and their prices fall, and longer-dated bonds are more sensitive to this than shorter ones. In a plan, bonds are usually asked to provide steadier income and to soften the swings of the stock portion.

Cash is liquidity

Cash, in the investing sense, includes bank deposits, money market funds and very short-term government securities. Its defining feature is not growth but availability. It is the money you can use tomorrow without selling anything at an unknown price.

The cost of that convenience is that cash has historically earned the least of the three over long periods, and its purchasing power tends to erode as prices rise. Cash held for decades tends to lose ground to inflation. Cash held for next year's expenses is doing exactly what it should.

The useful question is rarely which asset is best. It is which asset is best for money needed at a particular time.

Risk depends on when you need the money

Risk means something different for each asset. For stocks, the main risk is that prices are low when you need to sell. For bonds, it is that a borrower fails to pay or that rates move against you. For cash, it is that inflation quietly reduces what your money buys.

Time changes which of these risks matters most. A price decline is a serious problem for money needed next month and a much smaller one for money needed in twenty years, because there is time for recovery. The longer the horizon, the more the balance of risks tends to favor growth assets; the shorter the horizon, the more it favors stability.

Matching an asset to a goal

Suppose, for illustration, a family has three goals. They plan to replace a car in about a year for $40,000. They are saving toward a home purchase roughly five years away. And they are setting aside money for a retirement that is thirty years off.

The car money has a short horizon and a fixed cost, so it is a natural fit for cash. A market decline in the next twelve months is a risk this goal cannot absorb, and the small growth given up is a modest price for certainty.

The home purchase sits in the middle. Five years is long enough that holding everything in cash gives up meaningful growth, but short enough that a severe stock decline could arrive at the wrong moment. A blend is common for goals like this, with proportions that depend on how firm the date is.

The retirement money has decades to work. Short-term price swings matter far less than long-term growth, which is why a heavier weighting toward stocks is common for goals this distant, with the mix gradually shifting toward bonds and cash as the date approaches.

Because each asset carries a different kind of risk, combining them means no single risk dominates. Stocks supply growth, bonds supply income and ballast, and cash supplies readiness. The proportions, called an asset allocation, are among the most important decisions in any plan. How each asset is taxed can also vary with the type of account it sits in, which is worth reviewing with a qualified tax professional.

Questions to Discuss With Your Advisor

• Which of my goals are short, medium and long term, and what is each one currently invested in?
• How much of my portfolio is in stocks, bonds and cash, and why is that the right mix for me?
• How much cash should I keep readily available for planned expenses and emergencies?
• As a goal gets closer, how and when should its allocation change?