I Have Some Extra Cash but… 2%.. eh?
Ok so you are in a spot to have extra cash to put into Emergency Funds or stash for a bit but you are unimpressed with the yield. What’s the best way to, relatively, safely increase the yield? The age old answer lies in… Diversification. Likely no surprise to many but how little risk you need to take to boost your yield was kind of surprising even to me.
First Some Basics of My Short Term Portfolio Philosphy
I personally do not believe a pure savings account, money market account, CD, or any of the “traditional” savings vechiles make sense in today’s investing climate. I have shared this in previous posts but I’ll share it again here…. investment in a Short Term Bond Fund ETFs beat out all of these on multiple fronts:
- The principal is stable
- The yield is higher
- Lower lock out period / Liquidity – especially if you can hold off for the (typical) 30 day waiting period at your broker allows you free trades
- No minimum investment beyond “one share” (less than $100) while other vehicles requires larger sums
What are my go to securities?
SLQD – Short Term Investment Grade Bond ETF. 2.5% yield as of this post. Yahoo finance link: https://finance.yahoo.com/quote/SLQD?p=SLQD&.tsrc=fin-srch
BSV – Vanguard Short Term Bond ETF. 2.0% yield as of this post. Yahoo finance link: https://finance.yahoo.com/quote/BSV?p=BSV&.tsrc=fin-srch
FSHBX – Fidelity Short Term Bond ETF. 1.7% yield as of this post. Yahoo finance link: https://finance.yahoo.com/quote/FSHBX?p=FSHBX&.tsrc=fin-srch
You can look back 5 years or even the max distances for each of these securities – in a given year they really don’t move more than +/- 1% they stay within +/- 5%. Very stable securities with a yield.
OK – I get it 2%… How do I get MORE without much more risk
If you have never played around with diversification, in my eyes, it is amazing how just adding “risk” to 10% to 20% of your objective can significantly increase your performance even for an objective as simple as “short term debt.” Let’s prove this out with some math!
Assumptions to keep this simple:
- SLQD as our short term security – 2.6% yield as of the time of this post.
- SHYG (short term high yield debt) as our high risk diversification asset – 5.9% yield as of the time of this post.
- SLQD volatility assumed to be 0 – no change over time
- SHYG volatility assumed to be 0%, 10% decline, and 20% decline in the three scenarios modelled below. As a reference – if you bought at the highest high and lowest low over the past 5 years that would have been about a 15% decline for SHyg… in the last year the highest high vs. the lowest low was a 7.3% decline.
The Conclusion First….
By adding 10% of “high risk” asset to this simple portfolio – we increase the yield and overall total investment value after a year EVEN IF THE HIGH YIELD STOCK DROPS 20%! Think about that….. by adding risk – you increase your return vs. solely investing in the low risk asset. Let’s show the math before we discuss further…
Analysis – Table View
Analysis – Chart View
Ok back to that Crazy Conclusion….
The net results of adding 10% of our sample risker asset increased our yield from 2.6% to 2.9% in this scenario and if we held for a full year.
What happens to the principal is interesting:
- If the high risk asset takes a 20% hit – the total value of the portfolio (Assuming no reinvested dividends) would still be above our base portfolio value of $1,000. This would be a rare event but this shows that your short term portfolio can take a hit. This is shown in the ORANGE bar.
- If the high risk asset takes a 10% hit – the total value of the portfolio (Assuming no reinvested dividends) would still be above our base portfolio value of $1,000 but even by a higher degree. This is shown in the GREY bar.
- If there is no hit (or even appreciation) – you expose yourself to upside potential on the portfolio! This is shown in the YELLOW bar.
The summary is a micro experiment. In the event of a 20% decline in the high risk asset within a given year – it is highly likely that the short term asset will also go down as well as that is a likely a black swan event. Everyone likely recognizes that but let’s call a spade a spade.
The second is something that others might point out – specifically that bonds are typically correlated and it is possible that short term investment grade and short term high yield may run in parallel and amplify any down risk…. I have disproven that with the chart below – SLQD does have its value wiggle but only by 0.5% since 2014 and has been highly stable as SHYG acts more like a stock.
The third and final…. why does this make sense? If you really think about it by keeping 90% of your principal “safe” the 10% “risk on” you are adding is just boosting your overall yield. The yield increase is offsetting the potential decline in principal value. This “risk on” theory is consistent with The Efficient frontier of Modern Portfolio Theory. There simply is a point when you are taking “too little risk”
Here is the chart I referenced above for #2:
You Don’t Need to Use “Risky” Assets for This Strategy Either.
I used a higher risk asset today so show off the volatility (SHYG does swing) – but your “additional risk” in your portfolio doesn’t have to be “High Yield Debt.” You could supplement with VNQ – Vanguard’s REIT that is yielding 4.6% or LQD – Investment Grade Debt that is yielding 3.6% as of the time of this article. The math obviously changes for each one of these scenarios but the core principle stands if you are trying to boost yield on your short term portfolio: Adding higher yielding securities as a small percentage of your portfolio helps boost yield without a significant amount of incremental risk.
So In Conclusion….
I get it – emergency funds and short term investments are usually there to park cash for something in the near term. But 100% of all of that cash in the safest asset class you can find? Math would argue that a little risk goes along way without exposing you to much downside risk.
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