Better Safe Than Sorry in Short-Term Portfolios

Jason Stipp: I'm Jason Stipp for Morningstar. It's Model Portfolio Week on Morningstar.com, and today we're talking about investments for those shorter-term portfolios that you might have with Christine Benz, our director of personal finance.

Christine, thanks for joining me.

Christine Benz: Jason, great to be here.

Stipp: Let's say that I'm investing for a very short time horizon--two years or less. What types of investments do you think are most advisable for those really short-term kinds of goals and investments in portfolios?

Benz: Unfortunately, the pickings are pretty slim right now for investors. I think that given the risk/reward profile of most bond funds, investors who have very short-term income needs are going to be better off in some sort of highly liquid cash type accounts. Right now, the online savings banks tend to have the most competitive income streams with daily liquidity. In many cases, you can find yields of about 1%. That's going to beat what you can earn on most money market mutual funds currently--and, of course, money market mutual funds don't guarantee the stability of your principal. They are not FDIC-insured. So, I think for the best combination of yield and safety, those online savings accounts--even though a 1% yield doesn't sound like a lot--are probably the best place to be.

Stipp: And given such a very short time period, you are saying that there are plenty of investments you should avoid. I think we can agree stocks, for sure; but there are even seemingly safer investments you might also want to shy away from for these short-term portfolios.

Benz: Right. Ultra-short-term--or certainly short-term--bond funds would be two other categories that I would say should be off limits if your time horizon is two years or shorter. Ultra-short-term funds, oftentimes, have very short duration, so that might seem appealing--that ability to dodge a lot of interest-rate-related volatility--but they will have some interest-rate-related volatility. And more important, one thing we've seen when we look across this category of ultra-short-term funds is this propensity to take on credit risk. A lot of managers seem to be betting, "Well, we're not sure about what interest rates might do, but we're pretty sure that credit will be OK." So, they're taking on a little bit of credit risk. We've been seeing some of these funds nudging out on the credit spectrum. I think that's a risk that investors need to bear in mind. It probably is not a good bet to make. I'm not saying that credit is going to go sour anytime soon, but you want to be careful. These funds probably have more risk than many investors are bargaining for if they have very short-term time horizons.

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I would also put bank-loan investments in the category of something to avoid for a very short-term time horizon. I know some of them have been sold as good alternatives--a way to pick up a little bit of extra yield on your cash. And yes, they are very attractive in the face of a rising-rate environment; but there, too, with this investment type--with bank-loan funds or floating-rate funds--you typically do have a fair amount of credit-quality risk. So, I think you want to be careful. These investments, while they might be nice additions to investors' tool kits, are probably better if you have a longer time horizon of, I would say, at least five years for the bank-loan investments.

Stipp: Let's say I have a somewhat longer time horizon--maybe saving for college in five to seven years. What kinds of investments might be on the table for me in that case?

Benz: Probably you want to be focusing mainly on bonds. Here, because you do have a slightly longer time horizon, I think you can tolerate a little bit of interest-rate-related volatility. You will receive a pickup in your yield. But I wouldn't venture into long-term bonds. I would focus primarily on short- and intermediate-term bonds. In some of the model portfolios, we've used some of the good funds from Fidelity and Vanguard as the anchor positions within the short-term or intermediate-term pieces of the portfolios.

Stipp: And if I'm thinking about five to seven years, that seems like a reasonable time period. But you say some investments really still should be off the table even for five to seven years.

Benz: Stocks might be tantalizing. I think certainly when you look at the return history over the past five or six years, stocks have bonds beat by a wide margin. But I think you want to remember that even though stocks' near-term returns have been very good--and, longer term, they do tend to beat bonds and certainly cash instruments--they are not a sure thing over a time period of less than 10 years. So, when you look at stocks' returns over rolling 10-year periods, they are almost always in positive territory. But once you shorten that time horizon, the probability of having a positive return becomes that much less. So, I think you want to be careful. I think stocks are too risky if your time horizon is less than 10 years.

Stipp: So, with the shorter time periods, it sounds like you're saying better safe than sorry.

Benz: Yes, that's exactly right.

Stipp: Christine, thanks so much for joining me today.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.