“How do I save money for the short-term to accomplish financial goals like saving for a down payment? A vehicle purchase? An engagement ring for my sweetheart? Or a rental property purchase?”
These are questions that many young doctors ask us when we do our normal spew about long-term retirement investment.
Everyone has different financial goals in life that are beyond just amassing money to be financially free.
Typically, most Americans put any extra cash needed in a standard savings accounts like your local Bank of America or Credit Union, where the annual return is extremely low (~0.02%).
Shocking right? Especially when you consider annual inflation of 3-4% - you basically lose the purchasing power of the dollar with each passing year.
Therefore, short-term investment strategies are so vital in our financial plan.
What is Considered a Short-term Investment?
As a general rule, we will define a short-term investment as anything that will be spent in 5 years or less. The quicker you need the cash, the less risk you will need to take.
So, you might be asking…. Why 5 years? Studies show that that on an average, it takes about 5 years for the stock market to recuperate some of its losses and go back to baseline (or Zero) after a bear market period or significant market correction.
Is it a guarantee that the market will recover to baseline after a crash? NO.
If you look at the 1930s, there was a rather significant market crash (called the Great Depression) that even after 5 years still saw a loss of 60.9%. Fortunately, this scenario rarely occurs, however it does give us a glimpse of the inherent risk of the stock market.
What are 5 short-term investing vehicles?
1) Online High Yield Savings Account (Gain= 2.1 to 2.4%)
Still nothing to be excited about, Online High Yield Saving Accounts provide a better interest rate than 0.02% that you are getting from your bank and you are able to withdraw at any time. Also, they are still FDIC-insured, which means that the US government guarantees no losses of your funds. This is usually the most flexible and safest way to save for the short-term.
2) Certificate of Deposit a.k.a. “CD” (Gain= 1 to 2.5%)
With a CD, you agree to leave your money in the bank for a set amount of time (ranging from a few months to 5-20 years). The longer the term, the higher the rate of return. There is a penalty charged if you decide to withdraw prior to the maturation term, so it is critical that you select the correct timeframe. While it still doesn’t beat inflation, it is FDIC insured.
3) Short Term Bond Index (Gain= 1 to 4%)
You can invest with Vanguard for short or intermediate bonds, in either US government or Corporate. Government bonds will be more secure but will pay less compared to corporate bonds. Bonds for the most part are considered a safe investment but they are not FDIC-insured. We would recommend a total bond index fund.
4) Municipal Government Bonds (Gain= 2 to 5% after tax)
Municipal bonds are when you lend money to a state or local government, and they pay you back with a specific interest. The one great thing about muni bonds are that there are no taxes on the gain and is great for high-earning professional like us. Like bonds, you can withdraw anytime without penalty.
5) Lending Club (Gain= 5-7%)
Lending clubs are basically peer-to-peer lending platforms that allow investors to give loans to individuals or smaller businesses. Loans are usually set for 3-5 years. It is very easy to invest and have a diversified lending loan portfolio for a higher return, but you run the risk for default loans made, plus it is difficult to liquefy the non-FDIC funds into cash if needed.
Why NOT just take the risk and do Mutual Funds mixing Stocks and Bonds?
This is often a great debate between investors. Why not take the risk and put some of those short-term needed capital into the stock mutual funds and get a higher return like 10%?
It is difficult as an investor seeing the market rises 25% in one year (example: 2017) and looking at your puny little high-yield saving account earning a whopping return of 1.3%. However, with everything come with risks.
For example, if you were to invest $50,000 in stock mutual funds for a house down payment in 2007 (before the 2008 market crash) and hopefully withdraw it by 2010 for a future house purchase. You would have lost close to 50% by end of 2009, ending up with $25,000.
This would force you to leave your money in for another 3 more years to get to baseline, thus delaying your house purchase.
Therefore, the general guideline is to avoid investing in the stock market if you need the money in 5 years or less. It gives you time for your funds to get back to baseline and recover in the worst-case situation.
What about using the Roth IRA for short-term investing?
I know what you are probably thinking! “Whoa! Dat and Aaron, you told me that retirement accounts are for retirement and not to pull out at any cost." You are absolutely right.
For the majority of investors, we never recommend touching your Roth IRA for anything except for retirement. It is an amazing tax-efficient account with tax-free growth.
But as mentioned in the previous chapter on retirement, the one cool thing about the Roth IRA is that you can withdraw the contributions (post-tax money you put in each year, up to $6,000 in 2019 at ANYTIME and WITHOUT any penalty or taxes, mainly because you pay taxes on the incoming Roth IRA funds already). However, you cannot pull out the gains without penalty until you are 59 ½ years old.
Some investors fully fund their 401K and devote it to retirement, and use their Roth IRA contributions as a way for short-term financial goals like saving for a house down payment.
Just realize that you are losing that retirement money forever, along with any tax-free compounding growth as well.
Again, we do NOT advise using your Roth IRA as a way for short-term goals, but it is another option of investing if you are aware of the risks and consequences.
Short-term investing is an important tool that we need to have in our portfolio, because it allows us to accomplish many of our financial goals throughout our lives. While saving for retirement is an important aspect in personal finance, it is money that you cannot touch until you are much older.
You work hard day after day, sometimes even 6 or 7 days a week, so it is just as important to be able to enjoy the short-term joy of your money as well.