Invest for Short- and Intermediate-Term Goals

Just as putting and chipping look deceptively simple to beginning golfers, so can the process of investing for shorter time horizons trip up investors. It looks so easy, but it can be difficult to get right.

Investors may confuse their risk capacity with risk tolerance, for example, venturing out on the risk spectrum and incurring losses just before they need to tap their portfolios. Or they might assume that just because stocks have delivered returns that have bested other asset classes' in the past three years, they'll do it again during the next three.

At the opposite, conservative extreme, investors might assume that the best way to meet short- and intermediate-term goals is to stick exclusively with guaranteed products such as CDs or money market accounts. That's not an unreasonable idea given how small the current differential is between cash and products that do not promise stability of principal; for very near-term expenditures, cash is best. But if the investor's time horizon is longer than a couple of years, the bite of even modest inflation means that guaranteed products may well be a losing proposition.

Running the Numbers Investing for short- and intermediate-term goals is, in many ways, a game of probabilities. While the S&P 500 posted a positive return in more than 90% of rolling 10-year periods since 1986, stocks have been much less of a sure thing for shorter time horizons. Over rolling one-year periods December 2020, the S&P has posted a loss roughly 18% of the time. The index posted losses in about 12% of three-year windows over that same stretch. Some of those short-term losses were punishing, especially in one-year windows. The unlucky soul who invested in the S&P 500 in early 2008 and needed to get his money out a year later would have had to settle for a 43% loss, for example.

Meanwhile, bonds have a much higher probability of holding their ground over shorter time periods. During the same 25-year period, which was admittedly strong for bonds, the Barclays U.S. Aggregate Bond Index had a positive return in every rolling three-year time period and nearly 90% of rolling 12-month periods. And the worst 12-month loss for bonds was much milder than what stocks incurred at their nadir: just 3.7% (between late 1993 and late 1994). Of course, past is not prologue. In a sustained period of rising interest rates, bond losses could be higher and more frequent than they have been in the recent past.

What's a well-meaning short- or intermediate-term investor to do?

Well, even if bond returns aren't a sure thing to make money going forward, that doesn't automatically make stocks the better bet for short- or even intermediate-term time horizons. Historical returns suggest that if your time horizon is less than 10 years, stocks' returns have been too unreliable for them to be a worthy receptacle for the whole of your money. Stocks might be a component of a portfolio if the time horizon is close to 10 years, but they shouldn't be the whole kitty. Investors have even more reason to check their near-term expectations for stocks as they've been on an extended tear for most of the past decade and because valuations, while not at skyscraper levels, aren't especially low right now.

The answer is that if you're saving for a goal that's close at hand, whether a home down payment, remodeling, or a special family trip in five years, you need to take some risk but not too much. You also need to recognize the role your savings rate plays in all of this: If returns from reasonably safe asset classes are apt to be muted during your holding period--and current bond yields suggest they will be--you may need to step up your savings rate to achieve your goal rather than relying on portfolio returns to do the heavy lifting.

If you're investing for short- or intermediate-term goals, here are the key steps to take.

Step 1: Quantify goals and set time horizon. Start by identifying any financial goals you'd like to achieve in the short term (within the next one to two years) or intermediate term (within the next three to 10 years), along with their approximate cost.

Group your goals by short- and intermediate-term time horizons. If you haven't done so already, give some consideration to whether these short-term goals could impede your progress toward more-pressing long-term goals. As you quantify each goal, be sure to take into account inflation, especially for goals that have slightly longer time horizons.

Step 2: Consider where you'll be saving and investing. Because you'll pay taxes and/or penalties to tap your tax-sheltered retirement savings prior to retirement, it makes sense to invest for short- and intermediate-term goals in some type of a taxable brokerage account. You'll pay taxes on any income or capital gains that your accounts kick off during your holding period; you'll also owe taxes on any appreciation at the time you sell your holdings. But you'll also be able to withdraw your money whenever you need it.

If you're using a taxable account to invest for short- and intermediate-term goals, it's important to be tax-conscious. Municipal bonds and bond funds offer income that's free from federal tax and in some cases state and local, too; they can be a good fit for investors in higher tax brackets (32% and above) though their aftertax income won't always be higher than what you'd earn on an aftertax basis in a taxable bond/bond fund.

Step 3: Identify appropriate investments for short-term goals (less than two years away). If your time horizon is fewer than two years away, it's better to play it safe than reach for additional returns. Yes, yields on various cash instruments are ultra-low. But if you're so close to needing the money, you don't want to lose what you've managed to save. In other words, the downside of stretching for extra return via a short-term bond fund or floating-rate fund is greater than any return advantage that you're likely to pick up with these vehicles.

Here's an overview of the key investment types that make sense over your short time horizon:

• Checking and savings accounts
• Money market deposit accounts
• Certificates of deposit
• Online savings accounts
• Money market mutual funds

Step 4: Identify appropriate investments for intermediate-term goals (between three and 10 years away). For intermediate time horizons, you can consider taking a bit more risk than you would with money you expect to spend within the next few years. That means you'll be able to venture into high-quality bonds, which typically have higher yields than cash; if your time horizon is closer to 10 years, you could reasonably add a bit of equity exposure to the mix, too.

If your time horizon is more than two but fewer than five years: For short/intermediate time horizons, it's wise to play it safe, focusing on high-quality bonds and bond funds with shorter maturities/durations. You can lose money in such funds, but any such losses are apt to be quite small. The following investment types will make sense given your time horizon:

• Cash investments (such as those outlined above)
• Ultrashort-term funds
• Short-term bonds funds
• Short-term municipal-bond funds (if you're holding the money in a nonretirement account, municipal bonds/bond funds can make sense)

Here's a sample model portfolio for a taxable investor with a two- to five-year time horizon:

• 20%-40% Cash
• 40%-60% Fidelity Limited Term Municipal Income FSTFX
• 20% Fidelity Intermediate Municipal Income FLTMX

Here's a sample model portfolio for an investor in a tax-deferred account with a two- to five-year time horizon:

• 20%-40% Cash
• 40%-60% Fidelity Short-Term Bond FSHBX
• 20%: Dodge & Cox Income DODIX

If your time horizon is between five and 10 years: With a slightly longer time horizon, you can afford to take a bit more risk; you might even consider a dash of equity exposure, especially if you have a time horizon of close to 10 years. You'll also want to include ample cash and short-term bond funds, however.

The following investment types can make sense for time horizons of between five and 10 years:

• Cash investments (such as those outlined above)
• Ultrashort-term funds
• Short-term bond funds
• Short-term municipal-bond funds
• Intermediate-term bond funds
• Intermediate-term municipal-bond funds
• Conservative-allocation funds
• Moderate-allocation funds
• Large-company equity funds (in small doses)

Here's a sample model portfolio for a taxable investor with a five- to 10-year time horizon:

• 20% Cash
• 20% Fidelity Limited Term Municipal Income
• 40% Fidelity Intermediate Municipal Income
• 20% Vanguard Total Stock Market Index VTSMX or ETF VTI

Here's a sample model portfolio for an investor in a tax-deferred account with a five- to 10-year time horizon:

• 20% Cash
• 20% Fidelity Short-Term Bond
• 40% Dodge & Cox Income
• 20% Vanguard Dividend Appreciation Index VDADX or ETF VIG