Shares, bonds and cash: what role do they play in a portfolio?

When building a portfolio, the starting point should not be asking which instrument “earns more”, but understanding what role each component should play. Shares, bonds and cash are not three more or less profitable versions of the same investment: they address different needs. Shares are generally used to pursue long-term capital growth, bonds to introduce greater stability and more predictable cash flows, while cash primarily ensures immediate availability and reduces the risk of having to sell investments at unfavourable times.

The choice of instruments must be consistent with objectives, time horizon and the ability to bear risk. There is therefore no combination that suits everyone, because the appropriate role depends on the investor's situation.

Shares: growth and ownership in a business

Buying a share means becoming the owner of a small stake in a company. Returns may come both from an increase in the share price and from any dividends distributed. In exchange for potentially high long-term returns, the investor accepts greater volatility and the risk that the company's value may decline significantly.

CONSOB notes that shares can offer high returns but also expose investors to greater risks than more cautious instruments. Losses can be substantial and, if the company fails, shareholders are among the last to be paid after creditors.

The principal role of the equity component is therefore long-term capital growth. This does not mean shares always rise or suit every objective. If the money must be used within a few months or years, heavy equity exposure may be inappropriate because a market downturn could coincide with the time when the capital must be withdrawn.

Time makes risk easier to manage; it does not eliminate it

Shares are often associated with long-term investing because a broader horizon allows temporary fluctuations to be endured more easily. If a market loses 20% and the capital is not needed immediately, the investor may have time to wait for a possible recovery.

This does not mean time turns shares into safe investments. An individual company can fail, and an entire market can experience long periods of weakness. Diversification therefore remains essential.

The Bank of Italy emphasises that, as the time horizon increases, it may be possible to accept a larger allocation to more volatile instruments, but always in relation to personal circumstances. (economiapertutti.bancaditalia.it)

Shares are therefore a component geared towards growth, not a guarantee of growth.

Bonds: lending money rather than becoming an owner

Buying a bond instead means lending money to an issuer, which may be a government, bank or business. In return, the issuer generally undertakes to repay principal at maturity and, where applicable, pay periodic interest.

Bonds are debt securities: buyers become creditors of the issuer rather than owners, as they do with shares.

Their portfolio role can differ from that of shares. Bonds can introduce greater predictability into cash flows, reduce overall volatility and allow future maturities to be planned, particularly when held until repayment and when the issuer can meet its obligations.

But bonds also carry risks.

Bonds do not mean risk-free

One of the most common mistakes is to regard any bond as a safe investment. In reality, there are at least three fundamental risks: credit risk, interest-rate risk and liquidity risk.

Credit risk concerns the possibility that the issuer cannot pay interest or repay principal. A bond issued by a heavily indebted business carries very different risk from a government security issued by a highly creditworthy borrower.

Interest-rate risk instead concerns the bond's market price. When interest rates rise, existing bonds with lower coupons tend to lose value because new securities offer higher yields (the inverse relationship between interest rates and bond prices). 

Finally, there is the risk that a security may be difficult to sell quickly at a fair price.

The bond component therefore tends to be less volatile than equities in many situations, but should not be interpreted as a simple “safe zone” within the portfolio.

A bond's maturity significantly changes its risk

Two bonds issued by the same entity can have very different risk levels if one matures in a year and the other in twenty years.

Longer bonds generally tend to be more sensitive to interest-rate changes. This means that, if rates rise rapidly, a long-dated security can lose much more value than one approaching maturity.

When using bonds to stabilise a portfolio or fund a future objective, it is therefore necessary to consider not only the issuer's quality but also duration.

A bond portfolio with extremely long maturities can be far more volatile than the simple label “bonds” suggests.

Cash: return is not its main purpose

Cash is often treated as “useless” capital because it generates low returns. But judging it solely by return ignores its purpose.

Cash primarily ensures immediate availability, covers current expenses, meets emergencies and funds very short-term objectives without requiring other investments to be sold.

The Bank of Italy emphasises the importance of keeping easily accessible resources for unexpected needs and separating money intended for short-term spending from money invested over longer horizons.

The cost of cash is its low return and the loss of purchasing power caused by inflation. The benefit is the certainty of being able to use the capital immediately.

Why holding cash can also protect investments

Imagine someone with 100,000 euros fully invested in shares and no emergency fund. If they suddenly needed 10,000 euros while the market was down 30%, they might be forced to sell at a loss.

A second person with 90,000 euros invested and 10,000 euros in cash could instead use the reserve without altering the portfolio during the downturn.

In this case, cash did not produce a high financial return, but it performed an important role: it protected the rest of the portfolio against the risk of a forced sale.

Its value is therefore not measured solely by the interest it generates.

The three components answer three different questions

In very simplified terms, each component can be associated with a question.

Shares answer: “How can I seek to grow capital over the long term?”

Bonds answer: “How can I introduce greater stability and plan cash flows or maturities?”

Cash answers: “How much money must I be able to use immediately without depending on markets?”

A portfolio can be viewed as a combination of these three needs.

This does not mean every portfolio necessarily has to contain all three. Someone with particular needs may have a different structure. But this distinction helps avoid treating all assets as interchangeable solely on the basis of return.

Asset allocation: deciding how much to devote to each role

Choosing the percentages to allocate to shares, bonds and cash is called asset allocation.

It is one of the most important decisions in portfolio management because it largely determines overall risk.

Imagine three simplified portfolios:

Portfolio A tends to be more cautious and liquid. Portfolio C is strongly geared towards growth and accepts greater volatility. Portfolio B sits between them.

No portfolio is best in absolute terms. Everything depends on who will use it and for what objective.

A young person should not automatically hold 100% in shares

One of the most widespread rules says a young person should be almost entirely invested in shares because they have many years ahead.

The reasoning has some logic, but is incomplete.

Age alone does not determine the time horizon. A 25-year-old may want to buy a house in two years and therefore need a substantial portion of capital in low-volatility instruments. A 65-year-old may instead hold capital intended for heirs and therefore have a very long horizon for part of their wealth.

The Bank of Italy indeed emphasises that the choice should depend on objectives, time horizon and risk tolerance, rather than simply chronological age.

Bonds can also be used for specific objectives

Suppose someone knows they must pay 20,000 euros in five years. Instead of investing that sum in shares, they could use bond instruments consistent with the objective's date.

The logic is to match the investment's maturity as closely as possible to the date of the future expense.

If the money is instead needed in thirty years, accepting greater volatility in pursuit of higher growth may make sense.

This demonstrates that a portfolio should be built starting with time-bound objectives rather than an abstract idea of maximising returns.

The risk of holding too much cash

Although some cash is necessary, an excessive amount can become inefficient.

Suppose someone already has an adequate emergency fund, no substantial expenses planned over the next few years and still holds 80% of their wealth in cash or deposits paying almost nothing.

In that case, the portfolio may be too cautious relative to long-term objectives and suffer a gradual loss of purchasing power.

Cash should therefore have a specific purpose. Once emergencies and short-term needs are covered, any excess should at least be assessed against other objectives.

The risk of holding too many shares

The opposite mistake is concentrating almost all wealth in shares because they have historically delivered high long-term returns.

If the portfolio loses 40% and the investor cannot psychologically withstand that loss, they may sell during the crisis itself.

An asset allocation that is theoretically efficient but impossible to maintain in reality has little use.

The equity component must therefore be compatible not only with the time horizon, but also with the financial and psychological ability to accept fluctuations.

The risk of holding too many bonds

A heavily bond-based portfolio can also be unsuitable.

If the horizon is very long, excessive concentration in low-return instruments may reduce the ability of wealth to grow in real terms. Moreover, if the bonds have very long durations, the portfolio may be more sensitive to interest rates than imagined.

This is why the distinction shares = risky and bonds = safe is too simplistic.

Every asset class contains very different levels of risk.

Returns must be assessed alongside purpose

Suppose that in a given year shares return 15%, bonds 3% and cash 1%.

It might seem obvious that cash was the worst component.

But if that money was needed to pay an expense scheduled six months later, cash fulfilled its role perfectly. Investing it in shares in pursuit of 15% would have meant taking unnecessary risk.

Likewise, if capital intended for a thirty-year objective remains entirely in cash for decades, it may not fulfil its growth role effectively.

A component's return should therefore be judged against the role it is meant to play.

Rebalancing means restoring the portfolio to its original role

Percentages change over time. If shares grow much more than bonds, the equity component gradually becomes more significant and the portfolio takes on more risk than in its initial structure.

Rebalancing means periodically bringing the percentages back towards their established levels.

Suppose the initial portfolio consists of 60% shares and 40% bonds. After a strong equity rally, it could become 75%-25%. If that allocation is no longer consistent with the investor's profile, rebalancing means reducing part of the component that has grown and increasing the one that has shrunk.

Rebalancing is not intended to predict which market will rise. It maintains the chosen risk structure.

Three “buckets” for three time horizons

A simple way to interpret a portfolio is to divide it conceptually into three areas.

The first contains money that may be needed soon: cash and very cautious instruments.

The second contains capital intended for medium-term objectives: bonds or mixed portfolios may fit here, depending on the duration and acceptable risk.

The third contains capital that can remain invested for many years: this portion can support greater equity exposure.

This is not a universal rule, but it helps link each investment to a specific role.

A complete example

Imagine someone with 100,000 euros and three different objectives: 15,000 euros must remain available for emergencies, 25,000 euros will be needed in five years for an already planned project, and the remaining 60,000 euros are intended for a long-term objective more than twenty years away.

Treating all 100,000 euros in the same way would be irrational.

The 15,000 euros earmarked for emergencies mainly require availability. The 25,000 euros with a five-year horizon require greater attention to capital preservation and maturity. The long-term 60,000 euros can instead support a more substantial growth component.

In this way, shares, bonds and cash are chosen not according to which seems most attractive at the time, but according to the role they need to play.

Conclusion

Shares, bonds and cash do not compete to establish which is the best instrument.

They serve different purposes.

Shares primarily seek capital growth while accepting greater volatility. Bonds can introduce stability, more predictable cash flows and better timing of funding needs, while retaining credit, interest-rate and liquidity risks. Cash ensures immediate availability and protects against having to sell investments at unfavourable times, but may lose purchasing power over the long term.

The right question is therefore not: “How much should I hold in shares, bonds and cash?” but: “Which objectives must I fund, when will I need the money and what level of risk can I genuinely bear?”

Only after answering these questions does it make sense to set the percentages.

A good portfolio is not one that assigns every euro the highest possible return. It is one that assigns every euro a role consistent with when it will be needed and the risk that can be afforded.