The Right Investments for Short-Term Goals

Question: My wife and I are both in our late 20s, and we've been trying to save in our retirement accounts. But we'd also like to buy a house within the next five years. What types of investments are appropriate? Should we just keep the money in cash, or can we take a little extra risk with an eye toward earning a higher return?

Answer: Any time you're saving for a goal that's close at hand, it's worthwhile to spend a few moments anchoring your decision-making in the numbers, and perhaps doing a little soul-searching as well.

Morningstar's  Asset Allocator tool can help you with the former task, allowing you to gauge the probability that you'll reach your financial goals given your investment mix, how much you've saved thus far, additional contributions per month, and the number of years you have to save and invest. You can then adjust the variables to improve the likelihood that you'll hit your financial goal.

For example, say you'd like to save up $25,000 for a down payment in five years, and you've already saved $10,000 and plan to kick in an additional $250 per month. If you hold all of your assets in low-yielding cash, Asset Allocator pegs the likelihood that you'd hit your goal at about 75%. That's not too bad. But forgoing the stability of cash and holding a bond-only portfolio improves the probability of success to 80%. Taking the portfolio to a 100% equity allocation takes your probability of success back down to 75%. Your return potential has gone up, but so has the potential for losses.

By tinkering with the asset mix, you can arrive at the allocation to cash, bonds, and stocks that gives you the optimal probability of hitting your goal given your time horizon and savings rate. In the case of my example above, the sweet spot appears to be a portfolio with about half its assets in cash, 35% in bonds, and a small slice (roughly 15%) of large-cap stocks. (Note that adding international and small- and mid-cap stocks to the portfolio doesn't improve its probability of success in a meaningful way.)

Of course, finding the right investment mix will also hinge on your own risk capacity, how flexible you are about your goal, and how willing you are to ratchet up your own savings rate if it means greater peace of mind. Are you set on having your down payment in hand five years from now and don't want to risk the chance that your investments will be at a low ebb when you need the money? If so, you'll want to err on the side of a more conservative asset mix, even if it reduces the likelihood that you'll earn substantially more than your goal amount. If, on the other hand, you're willing to defer your house-buying date if it gives you a shot at amassing a larger down payment, you can tweak the asset allocation to make it slightly more aggressive. Just don't go overboard with equities; taking your stock allocation much higher than the 15% allocation that Asset Allocator recommended in the example above will subject a short-term portfolio to bigger short-term fluctuations than is ideal.

Armed with a ballpark asset allocation, you can then turn to selecting specific investments. Morningstar doesn't provide ratings or data for cash instruments, but you can hop onto bankrate.com to shop around for certificates of deposit and money market funds with attractive yields. (If you opt for a money market fund, just be sure that its costs are nice and low--ideally, well less than 0.5%.)

For the bond component of the portfolio, you could keep it simple and go with a broadly diversified holding like  Harbor Bond (HABDX),  Metropolitan West Total Return Bond (MWTRX), and  Dodge & Cox Income (DODIX);  Vanguard Total Bond Market Index (VBMFX) is another broad-based option.

If you're more conservative and/or worried about rising bond yields, you could split your fixed-income weighting between an intermediate-term fund like the aforementioned offerings as well as a short-term bond fund. ( Vanguard Short-Term Bond Index (VBISX) and  T. Rowe Price Short-Term Bond (PRWBX) are two of Morningstar analysts' favorites.)

To the extent that you hold a sleeve of your short-term portfolio in stocks--and that's optional, especially for conservative types--focus on high-quality large-cap funds such as  Vanguard Total Stock Market (VTSMX),  Vanguard Dividend Appreciation (VIG), or  T. Rowe Price Equity-Income (PRFDX).

A version of this article appeared on October 19, 2011.