Time horizon plays a key role in investment selection. You need to understand when you are likely to need the money you have invested. The more volatility (fluctuation in value) that an investment is expected to have, the longer you should plan on holding it. This is because swings in investments can take some time to recover from. Let's go over an example.
Stocks are known to be extremely volatile. During the 2008 banking crisis, the S&P 500 lost about 50% of its value between November 2007 to February 2009 (1 year, 3 months). It took until March of 2013 ( 4 years, 1 month) for it to recover to the original value. Imagine if you put the down payment for a house into stocks during this timeframe.
Today we are focusing on investments that are expected to be needed in 5 years or less. In my opinion, if you have 5 years or more to let an investment mature you can be somewhat aggressive. 10 years or more moves into the aggressive stage. More than 20 years is very aggressive.
When looking at short term investments, a few things you should look for:
- low risk returns. Nearly everything has some risk but we are looking for almost no risk of losing our money
- low cost. We don't want to be paying a high fee to get into the investments because we don't have a lot of time to earn that money back.
- liquidity: we don't want to be locked into an investment that we can't move when we want.
Risk Versus Return
The higher the risk, the higher the potential return. Vice versa. This is not a new concept but it is important to remind everyone. You need to be realistic on your approach because taking on low amounts of risk is not likely to earn you large amounts in return. Taking on a large amount of risk can increase your chance of high returns but at what chance of success?
Consider this. Since 1980, the stock market has gone up about 81% of years. Not bad. Now take a look at the last 5 years returns by month (graph at the top). You start to understand short term risk as only 64% of the months had a positive return. These odds may be better than the casino but not by much.
For the short term time horizon of less than 5 years, I will split it into two subsets: less than one year and from 1-5 years.
Less Than One Year Time Horizon
In the financial world, a year is a drop in the bucket of time. With such a short time horizon, any money you invest probably should have a fixed rate of return.
So where do you put your money? There are a few options.
High Yield Savings Accounts (HYSA)
These are accounts to hold cash that pay you a fixed amount of interest. They are no different than a savings account you would keep with a local bank or credit union except for that fact they pay out higher interest (yield) then a typical savings account, as the name implies. They are insured by the FDIC so you don't need to worry about losing your money (up to $250,000). One of the few risks is inflation risk as they typically are not great at keeping up with rising costs.
I would suggest looking into online banks, such as SoFi, as they typically offer a higher interest rate due to not having physical buildings. Buildings cost a lot to keep so by not having them they save money and can in turn pay out more.
One thing I would caution you on is to read the fine print for any offer. You may see advertisements offering outstanding returns but these can have stipulations that you may not meet or only pay out interest on a limited amount and a lower rate on anything else. Also, be on the lookout for extra fees.
Keep in mind, the interest on these accounts is variable and can change at any time. They are not locked in.
Currently (August 2023), SoFi is paying out 4.5%.
Money Market Account
A money market account is an account you can open with a bank or credit union that provide similar benefits to checking/savings accounts. The difference is they generally pay higher interest rates than regular accounts though typically pay out less than high yield savings accounts. You think of them as having middle of the road interest rates sandwiched between regular bank accounts and high yield savings accounts.
One benefit is that they typically offer less restrictions than a HYSA. They can also offer the ability to use a debit card or write checks from these accounts. Another big benefit is that they are insured with FDIC (again, up to $250.000) so all or some of your money is backed by the government should anything happen to the bank.
Current money market funds are returning between 4-5% (August 2023)
Money Market Mutual Fund
These are a type of mutual fund where they invest in short-term investments. Unlike a money market account, there is no FDIC insurance on your money. However, it is unlikely you would lose a very large percentage of your money as the holdings in these funds are typically in highly rated securities. They earn income on investments (typically short-term bonds or certificates of deposit) but the funds themselves do not typically increase in price to generate returns.
The return on these funds typically move in conjunction with interest rates. Meaning, when interest rates go up so does the return on money market funds.
Current money market funds are returning around 5% (July 2023).
Between 2-5 Years Time Horizon
Now we will venture into a slightly longer time horizon that offers us a little more flexibility to weather through volatility. This additional latitude offers us a couple more options though you could use any of the options above as well.
Certificates of Deposit (CDs)
CDs are savings products that can be purchased through banks, credit unions, and even brokerage firms that offer a fixed rate of interest for an invested amount of money. They require that the money remain at the institution for the set duration or you could face penalties. They typically have durations between 3 months to 5 years. Once they reach the end of the time period, you are able to get your principle back and keep any interest you have earned.
It is possible to use them if you need the money in under a year but I would typically go to one of the other options because once you purchase a CD, you are locked into a contract and will likely have to pay a penalty if you pull out early.
Short-term Bond Funds
Bonds are similar to CDs in the sense they pay out periodic interest payments based on an original investment amount. Short term bond funds can include government bonds, corporate bonds, and other varieties along with different maturities. Be sure you understand the fund you are in and that it meets your needs. Rather than having to go through the hassle of purchasing individual bonds on your own, buying a mutual fund that holds these types of bonds can save you time and hassle. Here are some characteristics of short term bond mutual funds:
- The first is that they are able to be sold at any time, even before maturity This can be a nice feature if you are unsure of when you might need to sell them.
- While the interest rate on bonds is fixed, the price of the bond is not. The price can face volatility due to interest rate risk but this is likely minimal with the short durations.
- If you invest into funds that have corporate bonds, understand that the bonds are not insured by the government so they can lose money if the company defaults though with the short duration this risk is relatively low.
There is no shortage of places to invest your money. The key to success is understanding which investment fits your unique situation. The investments above all have their advantages and disadvantages depending on your time horizon and ability to handle risk. Understand that these options are likely not going to have the highest returns but will provide you with consistent returns and minimal risk of loss. Focus on what you want to get from the investment and if in doubt, give me a call and we can discuss.