Hopefully, everybody has been building a CD Step Stool or a Bond Step Stool (not a ladder) in this rising interest rate environment. A Step Stool is the smarter approach because the short end of the yield curve has been rising faster than the long end.

The Fed Funds rate is the shortest of the short end, given it is the overnight interbank lending rate. The idea is that the more the Fed Funds rate increases, the higher yields should rise for longer duration lending rates due to the time value of money.

But the market controls longer term lending rates, and the market is currently telling the Fed to bugger off. Investors have found comfort in longer term bonds because their risk appetite has diminished. They don’t see inflation on the horizon nor do they see rosy good times.

To understand why buying shorter duration bonds and certificates of deposits is the optimal financial move for your cash, let’s take a look at a simple bond yield table.

There’s a lot of uncertainty as we head into 2019. The Fed is expected to raise rates another two to four times. We’ve got a slowing housing market thanks to rising rates, rising inventory, and lower overall affordability. We also have constant geopolitical risk that never seems to go away.

As investors, we must properly forecast the future AND put our money where our forecasts are. To just forecast while taking no risk is like wanting to go straight to the corner office without putting in any work – it makes no sense!

I’m guessing one of the reasons why you enjoy reading Financial Samurai is that I’m not just pontificating about investing. I’m actively trying to build my net worth to live a middle class lifestyle in an expensive city. Sometimes I strike out. Sometimes I hit a home run. Hopefully, through self-reflection and through community feedback, we can make better investment decisions.

To get savvier, let’s look at what some of the top Wall Street strategists are forecasting for the S&P 500 in 2019. These folks spend 50 – 70 hours a week thinking about the stock market, writing research, and speaking to the largest money managers in the world. Surely, they know more than the average retail investors.

There are just a couple caveats. One, they aren’t putting their own money at risk or managing money for others. Two, they love to hedge their forecasts because that’s how they earn Managing Director-level compensation which starts at $400,000 a year in base salary and they regularly receive $500,000 – $3,000,000 year-end bonuses, especially if they can get their forecasts right.

Liquidity is overrated. Once you have about six months worth of living expenses saved, there’s really no need to hoard even more cash since you have insurance. If you do accumulate more cash, that’s called “cash drag” because cash returns have underperformed assets such as stocks, bonds, and real estate since the beginning of our financial markets.

Once you identify a trend, your goal should be to buy assets that benefit from that trend, and hold on for as long as possible. Of course, if you think an impending bear market is on the horizon, holding more cash is good. However, over the long-term, having too much liquidity I argue is a detriment.

When I first came to San Francisco in 2001 from Manhattan, I discovered that San Francisco property was so cheap compared to Manhattan property, yet wages were quite similar. Consequently, I bought all the real estate my salary could afford in 2003, 2005, and 2014, and held on for as long as possible.

Now, I foresee a similar long-term trend happening in the heartland of America because San Francisco and other coastal cities have gotten too expensive and technology makes living in a congested area while paying $4,500/month for rent, unnecessary and obsolete. Companies located in high cost of living areas can’t comfortably afford to hire workers, and the workers can’t comfortably afford to save for retirement and raise a family.

Every single one of my biggest investment wins has occurred because I waited 10 years or longer before selling. There was only one stock that I made an enormous return in just six months, but that was dotcom bubble luck. On the other hand, there are plenty of stocks I lost tons of money on because I got shaken out way too early. If I had held on, I would have been much better off. 

Invest with logic, not emotion

With interest rates rising across all treasury bonds, there comes a point where owning bonds becomes more attractive than owning stocks – where you’re willing to have a greater than 50% weighting in bonds in your portfolio. After all, treasury bonds offer a guaranteed return if held to maturity and they are state income tax free.

Even with the 10-year bond yield rising to ~3.25% on October 10, 2018 from just 1.46% on July 1, 2016, is 3.25% a high enough risk-free rate for investors to make a shift mostly towards bonds? Probably not.

In a research report written by Savita Subramanian, Head of US Equity & Quant Strategy at Bank of America Merrill Lynch, she believes the 10-year bond yield has to reach 4.5% – 5% before US equities start to look less appealing than bonds.

Take a look at this chart.