We’ve had it drilled into us that you should invest for the long-term. Save early, save often and use the power of compound interest. Am I right? But what if you have a short term goal, how should you invest for the short term?
Have you read the important notes? It’s a condition for reading this blog.
How should you invest for the short term?
Investing for retirement is a decade’s long process. Both in the accumulation phase and then in the spendown phase, so you’ve gotta play the long game. There is no shortage of material around to tell you how to invest for the long-term, and I would say most FIRE blogs are concerned with this key goal.
However, there are times in your life where you may have a short-term goal, such as saving for an older child approaching college years, or replacing a car in a few years. These are near-term spending requirements that you might want to meet with a saving strategy. But the key question is, if you save for a near-term goal, then what investment strategy will maximize your probability of meeting that goal?
Separate Buckets
You might not think about your obligations in different buckets, but actuaries certainly do.
You have many different obligations that you need to meet, and these range from the short-term, to medium term and the very long term. For example, you might have to meet the following obligations:
- Pay utility bills this month
- Meet the credit card payment at the end of the month
- Pay for some repairs on your house
- Pay your high school senior’s first year college fee
- Purchase a replacement car in two years
- Save for a down-payment on a house in 3-5 years
- Save for retirement
Now clearly some of these obligations are so short term that it only makes sense to meet them from current cashflow. You will be using your monthly salary (or other income source) to meet the short-term commitments like paying off your credit card. It would make no sense to invest for a month to meet this payment.
We’ve already discussed the long-term, but what about those medium term commitments that have a horizon of around 2-5 years?
You may want to set aside some money each year to pay for a car replacement in 3 years. But should you invest that money, and how should you invest it?
One Bucket
You may feel that you have one investment strategy and do not differentiate between near term, and long-term goals. This can be a particularly relevant viewpoint if you have significant savings compared to your obligations. If you think you will need to buy an $8,000 car (say) in three years and you have seven figure savings then adopting different investment strategies is unlikely to move the needle. Your dominant goal (usually retirement) will drive your overall investment strategy.
However if you need to meet a particular mid-term goal and you do not have the resources to fall back on, then optimizing your saving strategy is important. For example if you fail to save the $8,000 required for the car, and as a result you will have to take out a loan (sub-optimal), or raid highly appreciated after-tax savings and take the tax hit (also sub-optimal), then this will be of interest to you.
Hurrah for Short-termism!
For our example let’s suppose that you need to meet a nice round $10,000 payment in three years’ time. Either you could set aside $3,333 per year to meet this, or you could set aside a lower sum, invest it, and hope it grows to meet your obligation of $10,000. [Actually in my work I’m going to assume inflation is present and so you would need more than $3,333 in cash, since it deflates over time.]
The problem is that investing is rarely a certain game and we need to evaluate whether it is worth taking stock market risk over such a short period. You could luck-out and only have to contribute $2,500 per year, but the market could go south and you then run the risk that you have to make a large final contribution in order to shore up any deficiency.
Analysis
Yay, finally we get to some analysis!
As per previous analyses, I am going look at inflation adjusted stock and bond returns from 1802 to 2015. We are going to get into some ‘back-testing’ of different investment strategies. Let’s look at 10 different portfolios with varying stock/bond mixes, going from 0% equities to 100% equities in 10% increments.
First we will look at the minimum annual contribution requirement (MCR) to hit our $10,000 target after 3 years for a 60% equity portfolio.
So surprise, surprise it’s pretty volatile. That’s equities for you. There is no certainty there. Depending on which cohort your three year period experienced, you might have required upwards of $4,000 per year, or if you were lucky, as little as $2,500 per year. Remember a cash investment would require around $3,333 per year. So for this portfolio it is sometimes better than cash, and sometimes worse.
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Risk and Return
We need a way to think about the tradeoff in investing in equities over this short period. Let’s evaluate the cost and risk of each portfolio.
- COST – I’m going to quantify this as the median contribution rate required to hit our target.
- RISK – I’m going to measure this as the difference between the median and 95th percentile. In other words this is the additional annual contribution required to be 95% certain that I will hit my target.
The following risk / return chart shows all the portfolio results.
If you have read some of my other posts on 529 investing then you will remember that the vertical axis goes backward. This means that points in the top left corner are low risk and low cost portfolios – that it good! Ideally you want to get a portfolio that is as much in the top-left as possible.
But there is generally a trade-off. As you decrease the expected cost, you increase the risk that you have to plug a shortfall with a big cash contribution.
Look at the 100% equity portfolio. The cost is around $3,100. This means that you have a 50/50 chance of only having to contribute $3,100 per year to meet $10,000 in three years. But the risk is around $700. Which means that to be 95% sure of meeting your target you would need to contribute $3,800 per year.
In other words you have a good chance of doing better than cash, but there is a decent chance you could under-perform cash over this period.
What’s interesting is that the high equity portfolios do not look optimal at all. A better mix of cost and risk is perhaps 30%-50% equities. That is much less than is typically recommended for an early-retirement portfolio. The investment horizon makes a difference!
Cash is King(?)
In the world of investable assets, cash is the runt of the litter. But it does have a key benefit of retaining nominal value, and over this short time period inflation is not too important. So cash is a pretty safe investment. Note that for an early retiree cash is a risky investment since it loses purchasing power. (Have you been reading the inflation risk series from Karsten/ERN and I? Part 1, Part 2 and Part 3).
So let’s incorporate cash into our portfolio.
The blue dots show cash/equity portfolios. So the 30% blue point is a portfolio with 70% cash and 30% stocks.
You can see that an all cash portfolio with zero equities has zero risk (unsurprisingly) and a cost of around $3,420. Remember it’s not $3,333 per year because cash loses purchasing power.
It’s also unsurprising that as you progressively add equities to a cash portfolio the result is lower expected cost but higher risk.
Optimizing
We need a way to find the optimal portfolio. We clearly want a low cost and a low risk, so it makes sense to look at COST+RISK.
Recall that my COST is the median contribution, and RISK is the additional contribution to be 95% certain, so COST+RISK is just the total annual contribution to be 95% certain.
The following chart plots this measure.
We are looking for the lowest points on this chart, since that minimizes the cost and risk.
If we take a mix of equities and bonds, then 30% equities / 70% bonds produces the lowest annual contribution of around $3,600 per year to be 95% certain of meeting our goal of $10,000 after three years.
However check out the 100% cash portfolio – it is the lowest point. That has an annual contribution of $3,420 per year to be 95% certain of meeting our goal. Adding equities just adds risk, without sufficient reduction in cost.
Conclusion
I was surprised by this.
Maybe not Whoah! fall-off-my-chair surprised.
But, certainly mildly startled.
We all know that if you are investing for the long-term, such as early retirement, then you need to have a large proportion of your assets in equities in order to maximize your chance of success.
But this analysis is saying that in order to maximize your chance of success in investing to hit a target over the short-term, then you should avoid equities! I had imagined that the optimal equity allocation might be lower than for a retirement portfolio (say 30% instead of 70-80%), but I had not thought that cash would be quite so compelling.
So I’m (somewhat reluctantly) concluding that if you are saving to meet a specific target over 2-5 years and you absolutely have to meet this target then 100% cash is the way to go. But, if you have other resources and funds to fall back on then you could stick with your long-term asset allocation.
When Does Short-Term Become Long-Term?
Holy smokes! What a great question!
We believe that to meet a very long-term investment goal then a high equity allocation is optimal. It also seems from this analysis that to be sure of meeting a short-term goal then 100% cash is optimal. But when does the short-term become long-term?
Dunno.
I need to do some more analysis on this. (I do have other things I need to do ya’ know!) So stay-tuned, because I am eager to investigate the bifurcation of investment strategy from cash to equities and I hope you’ll join me on what will likely be a wild ride! (ok, I probably over-sold that last point, but if you’ve made it this far through the post then you gotta admit this is fun – right?)
Do you have a single asset allocation that you stick with, and don’t concern yourself with whether you have short-term or long-term obligations? What do you do if you have to meet a short-term obligation? Do you save in a special bucket to meet that goal? Or do you lump it all together with all your goals, including retirement goals?
Technical Notes
Note that I didn’t show the market portfolio that takes a tangency with the efficient frontier. That would be a combination of cash, bonds, equities and it would be a bit more efficient than the blue line of cash+equities above. But, hey, I’ve got other things to do here, blogging ain’t gonna pay the bills!
Super-Technical Notes
I cheated a bit with the cash investment. I just deflated it by a constant 3% per year. In reality I should have deflated it by the actual inflation that was prevailing over the historical cohort under the analysis. But given the short time period I didn’t feel it would materially change things.
© Actuary on FIRE 2018
Nice to see the analysis behind keeping cash for short term goals. Thanks!
Great, glad you liked it. Don’t be a stranger Dr Mom!
Great analysis! The nice thing with saving for FIRE is that I often just lower my retirement contributions prior to making a big purchase. But, that’s not an option for many people. And, this makes me extra grateful for my high yield checking account, which at least roughly keeps up with inflation. I don’t have to feel so bad for my cash on hand for our big purchases this year!
The only bit I would disagree with is if you decrease your retirement contributions to a point where it is tax inefficient or you fail to get the company match. But I’m sure you wouldn’t do that!
Is your high yield checking account held with an online bank? I’ve looked at a few in the past but have felt uneasy about transferring money to a bank without brick & mortar. Thanks!
I don’t remember where I read it (maybe Motley Fool?) but the advice was simply: don’t invest any money you know you’ll need in the next five years.
Maybe a little extreme, but it will keep you out of trouble.
Another way to deal with this is to have a range for a goal rather than a fixed number. Or more accurately, fix the annual contribution and determine your level of acceptable risk and then let the result float.
For instance: we would like to buy another property in 3 (ish) years. I don’t know exactly how much that property will be, but 20% of $300k is $60k and is a nice round number so there you go…there’s something of a goal.
So we’re doing our best to save around $20K/year, but it’s not earning 1% in a savings account. It’s going into it’s own “sub-portfolio” which is very bond/cash heavy but it does have some equity risk.
How much will that sub-portfolio be worth in 3 years? No idea. If it’s down a lot, then we either lower our budget for the new property (which was kind of arbitrary anyway) or we hold off for a 4th year to build some more capital.
This isn’t a great choice for say college tuition, but any major asset purchase like a car or a home has some wiggle room. 95% certainty that you have EXACTLY x-amount is not really that important (IMO).
Great post! I will be interested to hear about where exactly you find the long/short horizon to be. My guess is 5 years.
Yes, you’re right; you can be roughly correct on this stuff. I was being a bit overly analytical in my analysis, and that is not really how real life works. I think the sub-portfolio idea is good, and I’ve heard ERN use that.
On the long/short horizon I would have guessed three years before I did this analysis. So I was kinda surprised at the result. So based on this, I’m inclined to agree with you and go for five years. Stay tuned!
It’s mostly an artifact of our current life situation but I don’t bucket funds. Money is fungible thus there is no difference between short term and long term money mathematically.
Liquidity is another story as you’ve highlighted here in a slightly different way. To handle liquidity I ensure my entire portfolio can handle any short term emergencies and expenditures by keeping my overall allocation in a way to cover that and my risk tolerance. Early on that might be what your recommended here, but later in your career your safe allocation likely exceeds future near term expenditures. At that time I don’t increase bond allocation in respect to a known future expenditure as I already have possibilities built in via a manner that should cover almost all contingencies.
For real gaps there is always a near term drop in savings since I’m still employed.
To put numbers to it if you had a portfolio of 1.5 million and a risk tolerance that keeps 20 percent in safe assets then you have 30k in safe assets. At thirty k plus whatever you save a year almost any contingency is covered. So if you have a sudden 30 k liability your tolerance absorbs it. You have no reason to up it since that’s the point of the tolerance gap in the first place. You may or may not rebalance at time of usage.
Correction 300k I’m safe assets.
I agree with you here. Real life is never quite the laboratory situation in my posts. I’m like you, I have a material portfolio of pre and post tax savings, and a significant saving rate. So I just have one investment strategy and just buy stuff. That’s what I did with a recent car purchase. I didn’t spend a lot ($8k) relative to my income and savings, so it was straightforward to use savings.
In the 90’s till 2008 I bought a new car every three years. I basically came up with a scheme where I became my own leasing company. I paid cash for the first new car and started to trace the residual value. I’m sure there is an actuarial reason car leases last 3 years and my guess is that is the sweet spot between maximum profit and residual value for the lease company, which is also why the lease describes only 15K miles/year driving. As soon as I bought the car I started buying a muni-bond fund every month. In those days muni’s paid about 4% tax free, so I could reverse engineer the amount I would need to save/invest to buy my next new car given the per year miles residual value of my present new car in 3 years. My self lease cost me about $200 a month less than a commercial lease on the same car. Random fact worth knowing: It turns out somewhere around 60K miles finance companies won’t finance which dramatically begins to reduces the value of a car.
It’s interesting you have been conditioned by the Feds manipulation of the interest environment to really only think in terms of stocks cash and something like a 10 year. I do consider separate buckets for specific goals like this self lease deal. I would violate the bucket in case of emergency but I wouldn’t consider my self lease deal as a part of my net worth any more than I would consider my mortgage part of my net worth. Before I retired I put a new roof on my house, and installed Dade county spec hurricane windows. I also have $15K stashed for when I need to replace the A/C’s Those are cost of living obligations IMHO relatively independent of portfolio funding obligations.
I use this FV calc: http://www.calculator.net/future-value-calculator.html
I like it because it shows initial investment, subsequent investment, and compounded interest related to time. I think the bifurcation you described and risk appetite is going to be related to compounding. I started saving for my kids college at age 2. I saved tuition in a state fund paid all at once which guaranteed 120 credits of school, room, board and fees at any state funded U in the state. This way no matter what my kids had college paid for. I paid a one time payment of something like $22K.
I further funded a UGTM with$ 20K at age 3, all in diversified stocks. 15 years later (age 18) I had $47K in that UGTM. I withdrew around 10K per year for my kids lifestyle, summer abroad, plane trips, computers, phones, clothes etc, whatever she wanted/needed. At age 22 there is $15K left in the account to buy her a car/license and some insurance when she graduates in 2 months. About 60% of this plan was financed by compounded interest over 19 years total including only 4 college years of dispersal, aka free money. There were 2 major market crashes during this time but the all stock portfolio did fine. I figured the worst that could happen was I would have to put in some extra in case of poor SOR. So this is long term planning for short term distribution.
Those are my two real life examples, short term saving short term distribution using a bond fund, and long term planning short term distribution using a stock fund.
Great discussion
Those are great examples. I particularly like the short term leasing example. I think you’re adopting a very actuarial approach to that, and if I understand it correctly, you’re sort of immunizing your next car purchase with your investment strategy.
The idea is you need to drive, so I am playing two things off each other predictable loss of residual value vs “predictable” investment growth in a bond which leverages me some free money due to accumulating interest, to pay the least for my driving. The bonds are tax free so I don’t have to count that. A New car every 3 years means it’s under warranty virtually the entire time and the residual value remains relatively large unless you drive a ton of miles so you only need a relative little bit of money to flip the deal. As I tore apart leases I realized these were already tuned for best efficiency for the leasing company in terms of profit so I just copied and made myself the lease company. The buy-in is having enough money to pay cash the first time for a new car. If you buy a year old new car you can realize a little more discount on the first car. You can also play with the length of time you own the car. Eventually I went to a 4 year term so between my wife and I, one or the other was getting a new car every 2 years.
The same is true for rental companies They basically buy a model year the minute it goes on the market eg a a 2015 is purchased in aug 2014 and they sell it off in 2017 so the used car looks like its 2 years old and holds a 2015 residual value but the car is closer to 3 years old in terms of the profit it provided to the rental company. It’s very actuarial. I purchased my kids a couple rental company used cars and have been pretty happy with those deals. They run them till the warranty runs out based on mileage and then send them to their own car lots for no haggle sale so the residual value is pretty easy to figure out.
You can save up to $25,000 per person using super high yield savings accounts at 5%. Also if you churn credit cards then a good portion of them will have 0% intro rates for 12 to 18 months. Lastly, is it really that bad to take a 2.5% auto loan? If the expected return of your portfolio is greater than the auto loan APR, aren’t you better off?
Agree with you on the loan. Not necessarily a bad thing
You have way too much fun with this. Intuitively I have come up with the same conclusion about cash being better for the short term. My only question is why would you waste your time and considerable cash flow to save for a $8k Car? Let’s see you go for the gusto and get a 180k car!
Keep up the entertaining and insightful analyses.
Ha ha. Yeah a $180k car! I used the $8k as an example since I recently bought an $8k Prius!
There was a BBC news report the other day of a Premier League soccer play took delivery of a $250k Ferrari. His brother in law took it out and crashed it! Crazy money and crazy cars!
Fascinating and inciteful analysis.
I await with interest the answers to the question of when does short term become long term. Particularly if it shines some light on the nebulous statement that SOR risk is greater in the early periods of retirement than in the later. We are all trained by commentary that this may be around 10 years … but is it? 🙂
Man I hear you! We need some answers. I’m gonna get right on it!
I get the idea that money is fungible, as FulltimeFinance pointed out, but the buckets I use in my savings account help me visualize how much more I need to save. I’m not naturally frugal, so putting my money in buckets helps me create an environment of artificial scarcity so I don’t think I have a bunch of money and then go spend it. I applaud those of you who are naturally frugal! 🙂
Great post and discussion. I guess I mentally bucket. I have about 3 years of expenses in MMFs. Multiple years of expense in muni bonds. The rest is in equities.
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Interesting analysis. It is most probable that 100% cash will achieve a short term goal but I tend to be more bullish and apply 30% to 50% in stocks for such goals, particularly when the timeline is not strict. I have a savings goal coming up in the next 2 to 3 years and have just taken advantage of the stock market dip to put some of the cash into equities.