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Investing for Near-Term Goals

When we talk about how to invest your portfolio, we’re usually talking about retirement savings. And, therefore, we’re usually discussing the best way to invest over a period of multiple decades.

Of course, we all have some nearer-term goals as well: buying a home (or a second home), college for the kids, etc. So what’s the best way to invest money that you’re saving for those types of goals?

It depends. First, we need to back up a step and answer two other questions:

  1. How long will the money be invested?
  2. How problematic would it be if there was actually less money at the end of the period than at the beginning?

Let’s tackle question #2 first.

Can You Afford to Lose Anything?

If you know with absolute certainty that you’re going to need every dollar of that money and you’re going to need it on a specific date, then the answer is simple: Stocks can’t be a part of the allocation, regardless of whether we’re talking about a 3-year time frame or a 15-year time frame.

In such cases, my suggestion is to use fixed income investments (CDs or bonds) with maturities that match up with when you expect to spend the money. For example, when you’re 5 years away, any money that you save toward the goal in question would go into 5-year CDs. When you’re 3 years away, any money saved would go into 3-year CDs.

If, however, if things go poorly, you wouldn’t mind a) delaying the spending for a few years or b) spending less than you’d hoped, then you can afford to take on more risk. Exactly how much risk depends on what kind of time frame we’re talking about.

How Long Will the Money Be Invested?

If we’re talking about periods of 5 years or less, anything more than a very minor stock allocation is quite risky. From 1928-2009, there were twenty-one 5-year periods over which stocks* lost money on an inflation-adjusted basis. That’s about ¼ of the time. And in the worst of those periods, they lost approximately 45% of their value.

For periods of 5-10 years, I think it becomes reasonable to consider allocating some of the money to stock holdings — though still a small portion of the total amount. And still only if you’re OK with the possibility that your portfolio could be worth less at the end of the period than at the beginning. By way of example: Eleven 10-year periods from 1928-2009 had negative inflation-adjusted stock returns, with the worst being a loss in value of approximately 38%.

Even for periods of 10-20 years, a good-sized helping of bonds is in order. While history shows that stocks are likely to put up decent returns over that kind of time frame, there are no promises.

*As measured by total return on the S&P 500 and (prior to the creation of the S&P 500) the S&P 90.

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  1. How many 10 year periods did bonds have negative inflation adjusted returns since 1926?

  2. My data only goes back to 1928, and it’s only for the total return on 10-year Treasury bonds. Using that data, though, there were thirty 10-year periods of negative inflation-adjusted total return.

    If anybody has such data for short-term bonds, I’d be interested to see how it differs.

    More importantly though, I think we now have access to an investment with significantly lower risk of negative real returns than was available for most of that 1928-2009 period. (That is, we can invest in TIPS.)

  3. Tom Ittelson says:

    You seem to forget about what inflation can do to drop purchasing power.

  4. Tom: What makes you say that?

  5. I am saving up to buy some property and I will need the money in about 3-4 years. I can accept some risk, but not too much, as this will be for a home we will be building in 4-5 years. What is the best investment for such a short period, as I will be adding money over time – about 12oo/month? Any advice appreciated.

  6. Hi Mark: They’re not very exciting, but I’d probably just use CDs if it were me. Just buy the farthest-out maturity that will still mature prior to the date you expect to need it. In between purchases (and after the CDs mature but before you spend the money), I’d just go with a plain old money market account.

  7. Mike,

    One rule of thumb that I actually find is helpful, is that your maximum equity allocation should equal your maximum tolerable loss X 2.

    Therefore, if you can afford to loose 10%, your maximum equity allocation should be 20%. Obviously there are many variables, but I find that this rule of thumb works well for both short and and long term investing.

  8. I find my self losing most of the money if I have the mind set that I can afford to use this money. From my experience, I would never advise others to have this mind set. Always tell yourself I cannot lose this money. This way you will not invest your money in risky areas. My2Cents.

  9. re: Michelle If you never invest in risky places then you will get about 1.25% on your money investing in CDs. If you’re satisfied with that then go for it!

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