As investors, we often try to bucket our expected expenses into categories, and make investments that are appropriate for the timeframe when the expense is likely due. This is logical, and often, a longer time horizon makes sense. For example, if retirement is still 20 years or more into the future, the investor may own stocks, stock funds, and intermediate term to longer-term bonds and bond funds. These types of securities can carry higher risks, but can also provide the potential for higher returns. However, when it comes to expenses that might be coming due in the next 3 years or less, a different philosophy may be required. Investments intended for short-term expenses should try to avoid significant principal risk, since there typically isn’t enough time to make up for losses.
Planning for the short term
By assessing their short-term financial goals and the investment strategies available to help achieve them, astute investors can seek to minimize volatility, protect against principal loss, and attempt to maximize their rate of return. A spectrum of shorter-term investments is available that aim to achieve this delicate balance of risk mitigation and return generation.
Three investment types that may serve investors with short-term financial goals are money markets, Ultra-short term bond funds/ETFs and short duration (term) bond funds/ETFs. The below table compares the risk/return potential, maturity dates, and typical holdings of these investment types:
|Money markets||Ultra-short term bond funds/ETFs||Short duration (term) bond funds/ETFs|
|Lowest Risk||Low risk, but higher than money markets||Low risk, but higher than both money markets and ultra-short term bond|
|Lowest Return Potential||Mid-range return potential, between money markets and short duration bond||Highest return potential|
|By rule, loans must mature in 13 months or less, but normally in aggregate, they mature in 60 days or less||Loans tend to mature between 6 months and a year||Loans tend to mature on average, within about 1-3 years|
|Most invest in treasury bills and investment grade commercial paper; traditionally regarded as safe instruments||Most securities tend to be investment grade rather than high yield, but investors should review the credit quality characteristics to be sure||Most securities tend to be investment grade1 rather than high yield2, but investors should review the credit quality characteristics to be sure|
Some short-term investors might consider dispersing short-term money among these three investment types, based on the investor’s comfort with risk and desire for return. However, instead of owning all three product types, some investors prefer to simplify their approach — splitting short-term investments into two vehicles: money markets and short duration (term) bond funds/ETFs. This structure can allow for more precision as it relates to short-term financial needs, with money market investments being used to help cover very short term or unexpected expenses like a leaky roof and short duration (term) bond funds being used to help cover a forthcoming fall or spring tuition bill, which might be several months to a few years into the future.
Preparing for rainy day expenses
Whether planning for the short term or the long, we suggest investors consult with a financial professional to ensure they have constructed durable portfolios that pursue better outcomes in all market conditions. A solid plan is particularly important for rainy day funds and money invested for the near term, since principal loss could have a negative effect on one’s immediate spending plans or unplanned expenses. Money markets, ultra-short term bond funds/ETFs, and short duration (term) bond funds/ETFs have the potential to play a role in the portfolios of investors looking to cover rainy day expenses.
2 High yield bonds are rated below BBB/Baa. Ratings are determined by third-party rating agencies such as Standard & Poor's or Moody's and are an indication of a bond's credit quality.
Exchange-Traded Funds (ETFs) trade like stocks, are subject to investment risk, and will fluctuate in market value. Unlike mutual funds, ETF shares are bought and sold at market price, which may be higher or lower than the ETF's net asset value. Transactions in shares of ETFs will result in brokerage commissions, which will reduce returns. Fixed income securities may carry one or more of the following risks: credit, interest rate (as interest rates rise bond prices usually fall), inflation and liquidity. Volatility management techniques may result in periods of loss and underperformance, may limit the Fund's ability to participate in rising markets and may increase transaction costs. Liquidity risk exists when particular investments are difficult to purchase or sell, possibly preventing the sale of these illiquid securities at an advantageous price or time. A lack of liquidity also may cause the value of investments to decline. Bond funds and individual bonds with a longer duration (a measure of the expected life of a security) tend to be more sensitive to changes in interest rates, usually making them more volatile than securities with shorter durations. Fixed income securities may carry one or more of the following risks: credit, interest rate (as interest rates rise bond prices usually fall), inflation and liquidity. Money Market Risk: An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund.
Unlike typical exchange-traded funds, there are no indexes that an active ETF attempts to track or replicate. Thus, the ability of an active ETF to achieve its objectives will depend on the effectiveness of the portfolio manager. Transactions in shares of ETFs will result in brokerage commissions, which will reduce returns.
Investing involves risk, including the risk of loss. Investment risk exists with equity, fixed income, and alternative investments. There is no assurance that any investment will meet its performance objectives or that losses will be avoided.
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed above may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted.