I often see questions about how to invest money in the short term, like 1-5 years. Sometimes it is phrased as “I need a safe investment for money I need in a year or two,” but doesn't give a definition of “safe” nor the reason the money is needed. A similar question was asked recently in the WCI Facebook Group:
Q. One of our kids has $40,000 she wants to invest. She wants a decent gain and for it to be liquid in one year. Therefore, she’s not going to put it in her stock or retirement accounts. Any wise advice would be appreciated!
Answers given were mostly excellent as usual such as this one:
although there were several that were not (admittedly some may have been said in jest):
Obviously I'm not a big fan of buying individual stocks, Bitcoin, or narrow sector ETFs at all. Acorns, (one of my worst-paying affiliate partners), for those who are unaware, is an interesting company that is really aimed at those with low incomes/balances but allows you to automatically invest very small amounts at a time into one of various solid diversified portfolios ranges from 20% stocks to 100% stocks for $12-36/year plus the fund expense ratios.
Investing For the Short Term
Let's talk for a few minutes about investing in the short run. There are really three considerations about short term investments we need to discuss here.
# 1 Liquidity
The first is actually the easiest — liquidity. Some investments are liquid and some are not. For example, for money you need in one year, it would be foolish to invest in something like an individual rental property. Direct real estate is terribly illiquid. At best, you can sell it in a few months, but you could potentially be forced to hold it for years longer than planned. In addition, there are transaction costs that would likely eat up most or all of the gain you would expect in a year. Even if you had a really great year, you could still lose all the gains just to the transaction costs. If you think a house is a one-year investment, you had better be a professional house flipper with a keen eye for opportunities.
However, many investments are plenty LIQUID to use for a one-year investment. Obviously a savings account, one year CD, or money market fund are liquid. But so also are publicly traded stocks, treasuries, ETFs, and most mutual funds. You can easily sell them any day the market is open. They do meet the liquidity criteria.
Although there are ways to get money out of retirement accounts penalty-free prior to age 59 1/2, retirement accounts generally aren't a good place for the young to invest short term money.
# 2 Risk of Loss
The second issue with short term investing is a lot more nuanced-risk. The traditional thinking has been not to invest money in stocks that you need at any point in the next five years. The reason for this is that stocks are quite volatile. According to Vanguard, an investment in US stocks lost money in 25 out of 92 years between 1926 and 2017. Although the annualized return over that time period was 10.1%, that ranged from +54% to -43%. That obviously introduces a lot of risk that you might not have the money you need in a year.
In those time frames, the return OF your principal often matters a whole lot more than the return ON your principal. By holding an investment at least five years, you reduce your risk of losing money, on a nominal basis, from 25/92 (27%) to about 10%. (In case you're wondering, there are no historical 15 year periods where stocks have lost money.)
The amount of money potentially lost also goes down extending out your investment period. The Balance has done a nice job of showing these in graphs.
That red line second from the right represents the S&P 500, a reasonable market for the overall US stock market. Instead of the worst loss being 43%, now it's only about 16%. At 5 years, that number drops to
about 6%. So if you invest money in the overall stock market, you have about an 11% chance of losing up to about 6% of your money. That seems like a much more reasonable risk to take than a 27% chance of losing up to 43% of your money, thus the 5-year rule of thumb.
# 3 Consequences of Loss
However, your personal risk is more complicated than just the risk of losing money. As I've explained before when I have advocated for investing your 529 more aggressively than your retirement account despite the shorter time frame, the consequences of loss matter too. You have to ask yourself, “How big of a deal is it if 5%-40% of this money is not there in a year?” If it is a really big deal, such as a wedding bill payment that must be made on that date and there are no other resources to pay it, then you had better not risk any loss at all. If it is a 20% house down payment you're investing for and you'll just use a 0% down doctor mortgage and leave this money invested for years if the market drops over the next year, then you can obviously weather the consequences of loss a lot better.
So, like all investing, it should come as no surprise that you cannot invest effectively until you know what you are investing for. You MUST start with your goals. You MUST consider all of your other resources. The more other sources of funds (including investments, earned income, passive income, and credit) you have, the more risk you can afford to take, even in the short run.
Once you add both risk and the consequences of risk into the equation, different people can come up with all kinds of different ways to invest money for 1-5 year time periods, all of which meet the liquidity criteria. But the same principles apply to short time periods as long time periods:
- Diversify broadly
- Keep costs low
- Capture market returns
That usually means using a mix of stock and bond index funds.
5-Year Short Term Investment
If you have five years and it's not a huge deal if some of the money isn't there in 5 years and it would be really helpful to make 10% a year instead of 3% a year, then maybe you want to invest it quite aggressively in an 80% stock/20% bonds portfolio.
1-Year Short Term Investment
If it is for 1 year and you could afford a tiny loss but not much more and you'd like to try to get a couple of percent more than you can get in a CD, then maybe a conservative portfolio like 20% stocks and 80% bonds is appropriate.
When Any Loss Isn't an Option
If you cannot handle the loss of any of this money and it must be available on a specific date in one year or less, well, that's what high-yield, FDIC-insured savings accounts or a money market fund is for.
What you don't want to do is go gambling. You've got a 48.65% chance of doubling your money by just going down to Vegas and betting it all on red. (and a 24% chance of quadrupling it and a 12% chance of 8Xing it etc). Admit to yourself that you have no idea what Amazon stock or a Bitcoin will be worth in a year. At least your odds are known at the roulette table.
The OP wanted to get a “decent gain” but did not define that. If decent is 2%, well no risk need be taken. If decent means 10%, well, how much risk of loss are you willing to take to get that 10%?
What do you think? How do you invest short term money and why? Comment below!