A common question I hear is what to do with money that you are saving for a short-term goal, such as a car replacement, a wedding, or a special trip. Let’s face it – nobody is getting rich off money markets and savings accounts in today’s world! But are you asking the right question? Let’s start with a couple of definitions:
- An investment is a property bought with the intent of creating wealth. Investing is along-term term process, a time period for you to let your property (stock portfolio, real estate, a partnership interest) grow in value. You should not meddle with your portfolio except to rebalance periodically (yearly for me). In the long term (which I define as 5+ years), your goal is to suitably diversify, reinvest income, and, most importantly, behave appropriately as a long-term investor.
- Savings, on the other hand, is money accumulated for a short-term goal. Since we define “long term” as at least 5 years, the short term is, by definition, a period of less than 5 years. In the short term, markets are very volatile, results are erratic and unpredictable, and we do not want to risk our savings by risking our savings for extra growth. While chances are that your investment will grow even in the short term, that’s just not good enough.
Buying property for short-term growth and income isn’t “investing” at all. It’s speculating (a.k.a. gambling). You should never count on an “investment” to grow much in the short term and you should not be surprised if it declines in value during that time frame.
Bear markets (defined as a sustained drop of at least 20% in the markets) have occurred, on average, every 5.5 years since the end of WWII. The stock market suffers a 14.1 % drop, on average, at some point every year. Is this a risk you are willing to take, knowing that you may have to put off buying a house for a 2 or 3 years? Of course, this assumes you wouldn’t panic and sell while the market is down 25%, turning a temporary drop into a permanent loss.
So what should you do with money you’ll need during the next 5 years? Actually…very little except to make sure it will be there for you. In the short term, income is of secondary importance. The fact that you may earn a bit of interest while your money waits for the next emergency is nice, but not something you should focus on.
You should allocate short-term savings as follows:
- Funds for unpredictable, current spending belong in a basic interest-bearing account. This includes your monthly living costs, your emergency account, and so forth.
- Money for “planned needs”, such as what you’ve set aside for a house when you finish training, should be loaned using debt (CDs and bonds) timed to mature when you will need it.
Remember: short-term priorities for your money are liquidity and safety. Long-term priorities for your investments are growth and income. How do you define which is which? By creating a financial plan, of course. Your plan should always dictate your financial decisions.