This article discusses the best ways to invest money that you'll need within 3 to 5 years, and how you can keep pace with inflation while not taking on too much risk.
Are the savings you'll need within a few years parked inmoney-market funds and CDs? You can do better.
In general, the longer you can keep your money working, the better yourchance of reaping big returns. The investments with the highest payoff potentialtend to give you the bumpiest ride. So to be sure they'll live up to theirpromise, you have to have the time, and the patience, to wait out downturns.
But what about cash you might need in five years or less, for emergenciesor planned expenses? Money-market funds and CDs are practically mattresssafe, but both offer meager returnsaround 5 or 6 percent lately.
If you need your money back within two years, you may have few options."Only money-market securities, CDs, or the very safest bond investmentscan provide enough assurance that the cash will be there in a couple ofyears," cautions financial planner Gary Schatsky of Albany, NY, andNew York City.
Suppose your time frame is on the longer side of shortabout three tofive years. Then you have quite a few choices. If you're willing to stomachstock-market risk to maximize your returns, you could even opt for a portfolioof equities selected with short-term performance in mind . But if you'remore comfortable parking short-term cash in less volatile alternatives,consider the ones that follow.
Bonds. Although generally less subject to wide price swings than stocks,bonds are by no means a sure bet. Their value fluctuates with interest rates;they can be called early, which cuts into your return; and they may notpreserve all of your principal.
But even though bonds aren't risk-free, they're generally safer thanequities, which makes them a traditional short-term play. And though bondreturns aren't dramatic compared with those of equities, they can be reasonable.
Moreover, with municipals, you can usually have safety plus tax advantages.Of course, the advantage is greater in higher brackets. "For someonein the 28 percent federal tax bracket, a tax-free muni that pays 5 percentis equivalent to a taxable investment paying 7 percent," says CarolWilson, a financial planner in Salt Lake City. "At 36 percent, it'sequivalent to 7.8 percent." If the muni escapes state and local taxes,too, the equivalent figure would be even higher, Wilson notes.
You need not stick to very short-term maturities. Like many advisers,Wilson often recommends "laddering"buying bonds with varyingmaturities, so that your holdings come due year by year. As one bond matures,you buy another to replace it and continue the cycle. This strategy givesyou an opportunity to benefit from fluctuating interest rates, while reducingthe volatility of your overall bond portfolio.
A couple of cautions: While you may hear zero-coupon bonds mentionedas short-term vehicles, you probably should avoid them for this purpose.A zero's principal will fluctuate wildly with changing interest rates, whichmeans you could take a big loss if you don't hold it to maturity.
A second strike against some zeros is that you don't get paid your interestalong the wayyet you pay current federal tax on it. One exception is municipalzeros, some of which are completely tax-free. Otherwise, zeros are typicallybetter for tax-deferred accounts.
Convertibles, too, are often touted as good short-term investments. Theseare bonds that you can transform into stock shares when the stock pricereaches a certain point. So you've got a shot at a stock's upside, withthe assurance of income along the way.
In general, though, unless you know a lot about individual bonds, leta bond expert choose them for you. Or stick with a no-load bond fund, whichspreads your risk over dozens of issues.
Bond mutual funds. The type of bond fund you purchaseone made up ofTreasuries, municipals, corporates, or some combinationwill depend onyour risk tolerance and when you'll need the money. "Sometimes, goingfor an extra two points in yield can mean risking up to 10 percent of yourprincipal," says Paul Mershon, a Phoenix financial planner. "Beforebuying shares of a bond fundor any investment, for that matteryou needto discuss with your planner what level of volatility you're comfortablewith."
For more on bond funds, plus specific recommendations, see "Wakeup that sleepy bond portfolio," in this issue.
Stock-and-bond funds. Balanced and asset-allocation funds can be excellentfor money you'll need within three to five years.
As the name suggests, balanced funds aim for a healthy blend of incomeand equity investments. For the short term, Wilson likes several such funds,including Dodge & Cox Balanced Fund and Vanguard Wellington. Financialplanner Steve Enright of River Vale, NJ, also favors Dodge and Coxandthe Invesco Balanced Fund, which returned 20.4 percent over 12 months.(All performance numbers are through Sept. 30).
"If you're considering these types of funds for short-term goals,examine their short-term performance," Enright says. "Invescohasn't had a three-year annualized return lower than 15 percent; the besthas been 25.1 percent." As for Dodge & Cox Balanced, it hasn'texperienced a negative three-year annualized return since 1975.
A fourth choice among balanced funds is the Vanguard Star Fund, whichhas a one-year return of 13.2 percent. It's one of Enright's favorites forshort-term money: "The management team invests in other Vanguard fundsincludingequity funds like Windsor, fixed-income funds like Vanguard Ginnie Mae,and money-market funds such as Vanguard Prime Portfolio." Since thosefunds focus on different areas, you should get a less volatile mix of investments.Vanguard Star has never had a three-year annualized return lower than 4percent.
Still, keep in mind that each fund manager has his own definition of"balanced." Some balanced funds own considerably more stocks thanothers do, but generally they hold a minimum of 25 percent of their assetsin fixed-income securities at all times. That could mean the differencebetween a safe short-term investment and a not-so-safe one.
Asset-allocation funds offer another way to get good short-term returns.The difference between these and balanced funds has to do with how restrictedthe managers are. "A balanced fund may be required to hold 40 to 60percent equities, but an asset-allocation fund has more leeway," saysEnright. That greater flexibility might put your mind at ease when the markethits an air pocket.
Consider Vanguard Asset Allocation Fund. On June 30, 1999, 37 percentof the fund's holdings were in equities, and 14 percent were in cash. Butin the preceding 12 months, Enright notes, the cash investment varied, andhad even exceeded more than 45 percent.
Vanguard Asset Allocation has a good long-term history and a goodshort-term record, according to Enright. "From the fund's inceptionin 1988, the overall return has been about 15.6 percent, and the annualizedthree-year return has never been less than 6 percent. For comparison, notethat the best money-market funds have been yielding 5.5 percent, and 2.5-yearCDs around 6.5 percent."
Life insurance. As investments go, cash-value life insurance hardly leapsto mind as a quick payer. Certainly, it's intended as a long-term vehicle.Moreover, the first dollars you put in often go straight toward commissions.Yet if you already have such a policy in place, it might provide an excellentway to get good short-term returns from extra cash. Even consumer-orientedinsurance expert Glenn Daily of New York City, who's skeptical about theindustry's products, concurs.
Here's why: Insurance investing typically gets big breaks. Not only isthe growth tax-deferred, but you can treat withdrawals as return of principalfirst, not taxable interest.
"If you have traditional dividend-paying whole life, then insteadof receiving dividends in cash or using them to pay premiums, you mightdo better using them to buy 'paid-up additions' to your policy," saysDaily. In effect, you'd be making additional short-term investments andtaking out the principal plus tax-deferred earnings. For example, Dailysays, suppose you use a $1,000 dividend to buy paid-up additions. "Ayear later, you might pull out $1,060 or so, with no taxes due. That's quitea good return."
You can use the same sort of strategy if you have a variable life policy,notes Paul Mershon. With such policies, you can put extra cash into theinvestment accounts the insurance company provides and allocate the moneyas you wish among various alternatives, such as stocks, bonds, and guaranteedaccounts.
"Suppose you've paid $50,000 into such a policy over the years,"Mershon says. "Now, looking for a safe short-term investment, you putin another $50,000say, into a conservative account paying 6 percent. Ayear later, you can take out $53,000your investment plus earningsbuttreat it all as return of principal."
Of course, you'll still owe tax on those earnings down the roadbutdown the road is, after all, the best place to pay taxes. "This isone of the best uses of insurance policies, yet people often don't thinkof it," says Daily. He does add some cautions: "Make sure yourpolicy allows this, and that the money going in won't incur a front-endload or a surrender charge on withdrawal, charges that might eat up muchof your return." And to assure the IRS that you're not just using lifeinsurance as a tax dodge, do this only with a well-established policy thatalready has plenty of cash value.
A couple more approaches. Sometimes you can get a better return simplyby investing more.
"Schwab has a 'value advantage' fund with a $25,000 minimum,"notes Carol Wilson. "It operates like a money market fund and has verylow volatility. So this is even okay to use for money you might need assoon as 12 or 18 months.
"As compensation for the high buy-in requirement, you get a higherreturn, maybe a half-percentage point better than a typical money-marketfund."
Planner Lewis Wallensky of Los Angeles might use such a fund as partof a multi-investment laddering approach for short-term situations. "Sometimesa client will come in and say, 'My kid is going to college this fall, andI've set aside $100,000but where should I put it?'
"Often, I'll suggest the four-bucket approach, essentially basedon how soon the money is needed: We might put the $25,000 earmarked forhis freshman year into a money-market fund. For the second year, we'd puthalf that amount into a money-market fund, half into a bond fund. For junioryear, we could invest $25,000 in an income fund. And the remaining $25,000,which won't be needed until senior year, might go into a growth investmentwithin a variable annuityif the client will be older than 59 1/2 by then,which will permit tax-deferred withdrawals."
So take the advice of that old planner, Motown singer Smokey Robinson:Shop around. Even though you're only in for the short term, you might findreturns that are both reasonable and reasonably secure.
Wallensky puts it this way: "Some clients who've come in with collegemoney set aside were about to park $100,000 of it in a 5 percent, six-monthCD, even though they needed the cash only gradually, over four years. Byconsidering other options, they got most of their money earning 6 or 7 percent,just as safely."
"In 1994, after graduating from medical school with hefty loans,my husband and I drew up a budget, to help us keep our spending in line.We use Quicken software to track everything we buy, including inexpensiveitems, like greeting cards and toiletries. Each week, we look at the totalto determine whether we're on budget.
"We also charge everything we can on two credit cards and payoff the balances each month. This gives us a record of most of our purchases.These steps have helped us make progress on several fronts: We've managedto save a little, pay down our school debts, and have a bit left for fun,too."
Katrina M. Hood, MD
Brad Burg. Get top returns on short-term investments. Medical Economics 1999;21:128.