Although the last decade has primed us to forget, stocks don’t always go up. The 10 months it took the market to recover from 2020’s pandemic-induced recession is a historical anomaly. Since 1992, the American stock market has produced a negative return in 15% of overlapping five-year periods. Short periods are even riskier. One-year periods have produced negative returns close to a third of the time.
This obviously doesn’t make stocks poor investments; it only qualifies the cases where they’re appropriate. Stocks, over long time frames (i.e., 10 years plus), almost exclusively go up. There have only ever been a handful of 10-year periods in American history where the stock market produced negative returns. There has never been a 20-year period where the market doesn’t finish higher, even when we account for inflation.
Not everyone has such a long-term horizon though. When it’s time to purchase a house or send a kid off to college, you need the money now, not in twenty years. For investors in these situations, stocks aren’t a viable investment, unless you’re comfortable with a one in three chance of losing money and, consequently, being unable to afford your down payment or your kids’ education. I know I’m not.
Most people, risk averse lawyers especially, tend to balk when presented with this dilemma. Many opt to pull their money out of the market and into a bank account several years before a major purchase to avoid any risk of negative returns. This isn’t ideal. Though the balance of your accounts will stay the same, inflation, the silent killer, inexorably chips away at its purchasing power. At a current rate of well over 6%, inflation is doing less chipping and more hacking.
Enter short-term investments. Investment options such as money market funds, CDs, and high-yield saving accounts offer some degree of returns while virtually guaranteeing safety of principal.
In the next couple of paragraphs, I’ll run through some of the questions you should ask yourself before investing for the short-term. From there, we’ll go over some of the most popular short-term financial vehicles, weighing the pros and cons of each type. We’ll then finish off with a quick discussion of why such vehicles aren’t always the best investment strategies. Less volatility and lower risk of principal loss are great, but there’s no such thing as a free lunch.
Are short-term investments for you?
Like any financial decision, the suitability of short-term investing depends on your investment objectives and risk tolerance. Only you can decide what these are. It may help to think of the decision as a two-part process.
First, ask yourself, do you have any large upcoming purchases? If not now, when will you? These purchases tend to be overlooked until they’re upon us. There’s nothing intuitive about calling a purchase five years away a short-term goal. Taking stock of your financial goals every few months is never time wasted.
Second, if you do identify an upcoming purchase, survey the current state of the short-term investment market. What is the rate of returns like? How about the risk? (We’ll run through the current state of the market at the end of this article.) You’ll need to decide whether the current returns of short-term investment options outweigh the reduced liquidity and added risk.
Deciding if an investment is worthwhile is a deeply personal decision. Some investors gladly accept reduced liquidity for a percent or two higher returns, even opting to hold their emergency funds in short-term investment accounts. Other more conservative investors would rather forfeit the extra return for the peace of mind that comes from having their money in cash. Neither side is incorrect. The choice that lets you sleep at night is the right one.
Whatever decision you make, don’t forget that financial risk manifests itself in forms beyond negative investment returns. Tucking your savings away in a checking account doesn’t shield you from all risk. The US dollar is a good store of value, but, thanks to the pernicious effects of inflation and the vicissitudes of foreign exchange markets, it’s not perfect.
Anyone who followed the news over the last year has been inundated with articles on the pandemic-induced rise in inflation. Investors who’ve left their money in cash over the last year have the same nominal quantity of dollars, but they certainly don’t have the same purchasing power as they did a year ago.
At the end of the day, we care about the real things we can buy with money, not the money itself. Short-term investments are a means of preserving your purchasing power when your financial goals preclude investment in the stock market.
The types of short-term investments: a (very) brief introduction
There are two boxes that the best short-term investments check.
First and foremost, they must protect your principal. You’re investing in short-term instruments because you need cash soon and can’t afford any losses. You can’t access that cash if negative returns have eaten away at the principal, even if those negative returns are temporary.
Second, a good short-term investment must be liquid. An investment stops being short-term if you have no way of quickly converting it to cash.
There are a variety of instruments that satisfy these two criteria, perhaps the most well-known being the certificate of deposit (CD). A CD is an agreement between an investor and bank, where the investor agrees to deposit and not touch a lump sum for a predetermined period. In return, the bank guarantees a fixed interest rate premium.
CDs are FDIC insured and offer a guaranteed payment, making them one of the safest short-term investments. This safety, however, comes at the cost of lower returns. Historically, money market and short-term bond funds noticeably outperform CDs.
Money market funds
For this reason, many investors instead opt for money market funds. Money market funds are mutual funds which hold a portfolio of very short-term debt with high credit quality. Share prices are locked at one dollar and profits are paid out in the form of dividends. When higher rates are found in the money market, a fund’s return on capital increases and more profits are paid out.
Unfortunately, since money market funds are mutual funds, they aren’t FDIC insured, though the risk of principal loss is tiny. The largest drawback is instead their sensitivity to interest rates. When rates are low (like right now), borrowers in the money market pay ridiculously low rates, lowering investor returns.
It’s important not to conflate money market funds and money market accounts, although the names are confusingly similar. It wouldn’t be investing if the names were intuitive! Money market accounts are essentially high yield saving accounts with added withdrawal restrictions. They typically return less than a money market fund but are FDIC insured and are extremely liquid, some even issuing debit cards.
Short-term bond funds are a final option for temporarily parking money. Such funds invest in government bonds and municipal bonds, as well as credit-worthy corporate bonds with short maturity dates, usually less than five years. Their exposure to the bond market has historically led to them producing the highest yields out of traditional short-term investments. At the same time, due to the short maturities of their holdings, short-term bond funds tend to have low interest rate risk, meaning lower chance of principal loss than stocks or longer-term bonds.
These funds, however, bear more risk than any of the other short-term investments discussed in this article. Temporary principal loss does sporadically happen over one-to-two-year periods. These losses do tend to smooth out over three-to-five-year periods, but if your definition of “short-term” is less than that, you may want to consider other investments.
Any of these classes of short-term investments can be purchased from a variety of providers. Like any other financial products, less-reputable providers offer higher yields than those of bellwether financial institutions. Online banks offer CDs and online savings accounts with higher APYs. Many also offer lower minimum investments and minimum balances. A little research goes a long way.
No free lunches
If you only consider their positive return with near zero risk of principal loss, short-term investments sound great, so great that foregoing stocks and other riskier assets may cross your mind. Taking a guaranteed few percent may sound perfect to a risk-averse lawyer. For someone who spends all day trying to ameliorate client risk, avoiding risk in her own financial life may seem a dream come true.
This strategy is flawed and needs a disclaimer. Low risk investments are viable over one-to-five-year periods, but, counterintuitively, this same lack of risk makes them extremely poor long-term investments.
It comes down to opportunity cost. You need to consider the returns you forfeit in the long run by staying solely in short-term instruments. Recall how this article began. Stocks, over long periods of time, have exclusively produced positive returns even when inflation is adjusted for. Short-term instruments, however, haven’t been as reliable. Their reduced volatility comes with a commensurate reduction in return, leading them to frequently be outpaced by inflation.
During the first couple of years, treading water in inflation-adjusted returns is fine; you just want to maintain purchasing power, and short-term investments do just that. Longer-term, however, you’ll continue to tread water if you’re lucky. If unlucky, you’ll lose purchasing power to inflation.
Meanwhile, a long period of time will allow fluctuations in the stock market to smooth, culminating in stock returns far out pacing both short-term instruments and inflation.
Here’s the takeaway: refusing to take on short-term risk leads to poor long-term returns. Avoiding riskier assets because of their short-term volatility is a textbook case of being penny wise and pound foolish.
Even within their designed scope, short-term investments aren’t risk free. Anything that isn’t FDIC insured carries risk of principal loss. Money market funds can “break the buck” and the value of bond funds can fall in the face of higher interest rates.
Even FDIC insurance isn’t a guarantee of value. While insured short-term investments – e.g., CDs and high yield savings accounts – protect you from principal loss, such instruments are still sensitive to interest rates. So, even if they’re insured, their returns can fall to near zero. At that point there’s no added return from locking your money up, and cash equivalents become an equally viable strategy.
Right now, savers have been hit by the one-two punch of the Federal Reserve slashing the interest rate and Congress pushing through trillions in fiscal stimulus. That’s Uncle Sam’s way of encouraging economic activity, which comes at the cost of making saving (e.g., in the form of short-term investments) unprofitable.
As a result, reputable five-year CDs are producing less than half a percent annually, Vanguard’s largest money market mutual fund returned 0.02% over the last year, and short-term bond funds’ yields have been negative. U.S. Treasury bills just don’t yield 6% anymore.
Fortunately, there’s a good chance that the Fed will start raising interest rates soon. (Raising interest rates is one of the tools the U.S. government uses to combat inflation.) Such raises would provide much-needed stimulus to the returns of short-term investments and likely lead to them climbing higher, back towards their historical averages.
Even if short-term investment returns stay historically low, it’s worthwhile to know some basic facts about them. A one to two percent return is better than nothing and the market is always changing. Check out this article for a peek at what the short-term market was like only two years ago.
Like any financial choice, deciding to move money into short-term investments isn’t easy. There’s no one-size-fits-all rubric for when it’s a good idea. You need to consider prevailing market conditions, your investment objectives, as well as your risk tolerance when deciding.
Still, while the particulars vary, there’s a few basic principles of short-term investing that almost always hold:
1) Short term investments are useful when you have a large purchase coming in the next one to five years.
2) Short term investments return more than cash or a typical savings account, while keeping risk of principal loss low.
3) CDs, money market mutual funds, high yield saving accounts, and short-term bond funds are among the most used short-term instruments.
4) Short-term investments aren’t a cure for financial risk. Any investment bears risk. Over long periods of time, short-term vehicles are even riskier than stocks.
How do you approach short-term investing? Anything I missed? Let me know in the comments.
Joseph Parise is a junior at the University of Buffalo. Joseph grew up in New York and is majoring in Philosophy and Economics. He is currently taking a gap year to study for the LSAT exam and to serve in the US Air Force Reserves.