Published July 20th, 2016 by Dirk S. Leach
There are times when the stock and bond markets just will not cooperate with our investment plans and goals.
It is beginning to look like we are in or fast approaching one of those times.
The equity market indexes are pushing all time highs and bond yields are pushing all time lows. Basic utility stocks are carrying price earnings ratios that I’ve never seen in 30+ years of investing.
While this is great for existing bond and equity investments, the stock and bond markets are looking frothy. Under these conditions what is an investor to do to continue growing their excess cash and dividend payments?
Wisdom From Warren Buffett
There are a couple of Warren Buffett quotes that come to mind that I believe are applicable to our current investing environment. The quote below is one that speaks to being highly selective in making your investments.
“I call investing the greatest business in the world … because you never have to swing. You stand at the plate, the pitcher throws you General Motors at 47! U.S. Steel at 39! and nobody calls a strike on you. There’s no penalty except opportunity lost. All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit it.”
The quote above is from 1974 and today, GM is selling for around $30 per share and US Steel about $21. It was certainly to Buffett’s advantage to let those two pitches go by without taking a swing.
Buffett’s advice is even more applicable today with the markets getting frothy. My translation of Buffett’s quote above is to be very selective in our current investing environment.
If you are going to invest in equities at these levels, a full understanding of a company’s business operations, cash flow, balance sheet, competition, and external risks is paramount.
This type of due diligence takes a lot of work and time on the part of the investor. Some investors don’t have the time available to devote to the necessary level of due diligence.
What strategy should investors follow if they don’t have the time to do the extensive due diligence necessary for selecting individual stocks? Another Buffett quote comes to mind that can provide us some guidance.
“Be Fearful When Others Are Greedy and Greedy When Others Are Fearful”
My way of interpreting the quote above is to take a step back from investing when other investors are bidding equities up into a froth. The other side of this same quote suggests that investors should be ready to invest when other investors are running from the market and driving the prices of equities down.
Today, we are definitely in the former situation of having high and increasing equity valuations. So, where should an investor put their idle cash while waiting for the market to offer better valuations?
Where to Stash Your Cash
Everyone should have some cash on hand whether to cover emergency expenses, six months of living expenses, or when you just don’t want to commit more to stocks and bonds.
But, for the past couple of years, the interest rates offered by the big banks and brokerage houses on their traditional money market funds and other deposit savings vehicles have been nothing short of abysmal, averaging about 0.1%.
This is just about the equivalent of putting your money into a Mason jar or under the mattress. My philosophy is that all your money should be working for you all of the time. I’ve also been known to squeeze a penny hard enough to have Lincoln cry out “UNCLE”.
For me, 0.1% just doesn’t cut it as an adequate return on my cash assets. Luckily, there are better alternatives for stashing your cash.
Short Term Bond Funds
One clear option is to use short-term corporate or municipal bond funds. These funds typically invest in bonds with maturities of two years or less. As long as you pick a fund that invests only in investment-grade paper, the credit risk is negligible.
However, market risk (rising rates) is still an issue but mitigated by the very short maturities of the bonds that make up the fund. All of the major fund families (e.g. Vanguard, Fidelity, T. Rowe Price, etc.) have short-term bond funds. Pick your favorite family, but be cognizant of the expenses/fees that management takes to manage the fund as this can materially lower your returns.
I have used both Vanguard and Fidelity. Both are excellent fund families and you would not go wrong with either. I prefer Vanguard as it has some of the lowest management fees in the industry. The two Vanguard short-term bond funds I have used the last few years are listed below:
- Vanguard Short Term Investment Grade Fund (VFSUX)
- Vanguard Short Term Tax Exempt Fund (VWSUX)
As of today, the SEC yield on the corporate bond fund is 1.61%, and on the tax exempt bond fund, 0.75%. The management fees are 0.1% and 0.12% respectively. The average maturity of the bonds in the tax exempt fund today is quite low at 1.6 years, and the current yield reflects this very short maturity.
Currently, I’m parking some cash reserves in the corporate bond fund because the tax exempt fund yield is low and my after tax return is better with the corporate bond fund.
There is one potential drawback to using either of the Vanguard funds listed above. Many – and maybe all – Vanguard funds other than their traditional money market funds include frequent trading restrictions. After making a redemption from either of the listed funds, the investor may not purchase additional shares of the same fund within a 30-day period. Yes, this is a bit of a pain, but I’ve found it workable over the years.
The other alternative I have found and currently use is online banks. These banking institutions exist online as websites and do not have extensive brick and mortar retail outlets.
The online banks don’t offer all the services that are provided by your local brick-and-mortar banks, but they also have a lower operational cost structure, allowing them to offer better rates on deposits. The online banks offer traditional money market accounts, high-yield savings accounts, and certificates of deposit.
I’ve compiled a list of those online banks that offer the highest interest rates and have good ratings for problem-free transactions and attentive and helpful customer service staff. All are FDIC insured and all are rated at least 4 star by Bankrate.com.
The rates, at first glance, don’t seem very impressive, but once you compare them to what you are typically getting on your brokerage settlement account or the money market fund tied to your brokerage account, the rates above start to look much better.
For example, the Vanguard Prime Money Market Fund, which is also often used as a brokerage settlement fund, currently yields 0.45%. The savings account rates in the table above are roughly 2.2x higher. If you are letting your cash account sit in a standard money market account or brokerage settlement account currently, the above list of online banks provides a much higher paying alternative.
I have used all of the banks listed above and found each website to be easy to use and the bank’s customer service organization to be helpful. Using Automated Clearing House (ACH) electronic funds transfers, I can move money to and from any one of the banks to my brokerage settlement account in 2-3 days and the transfer is free of charge.
When the market turns frothy, it is paramount to select your investments very carefully.
When you cannot spend the time for the due diligence necessary, the best approach may be to step back from the market and wait for better valuations before committing new money in the market.
Short term bond funds and online banks provide a safe and conservative alternative to parking your spare cash in your brokerage settlement fund or a standard money market fund.
Note: Combining dividend stocks with index investing as outlined here is also a potentially interesting way to park cash while waiting for better opportunities.
Whichever alternative you choose, 100% of your money should be working for you 100% of the time.