Investing

'All the probabilities change': How to optimize your investing strategy for short-term goals

"As your time horizon gets shorter, you want to take on less risk."

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If you're investing for a long-term goal, such as retirement, you'll likely receive a variation on the same advice no matter who you ask: Buy a low-cost, diversified stock portfolio and hold, roughly, forever. The calculus behind this thinking is easy enough to understand. Stocks are riskier than other kinds of investments but offer greater return potential. They'll undergo bouts of short-term volatility, but if you're decades away from your goal, they have plenty of time to recover from pullbacks.

But what if you plan to use the money sooner, say in the next one to five years, for a short-term goal such as putting a down payment on a house? "If you have a shorter-term time horizon, all the probabilities change," says Sarah Newcomb, director of behavioral science at Morningstar. "As your time horizon gets shorter, you want to take on less risk. If you take a hit, you may not have time to recover."

These days, that's easier said than done. Basement-low interest rates mean that stashing your savings in cash or short-term bonds will likely see you fail to keep up with inflation. Venture into investments with higher yields, and you may be taking on more risk than you want.

Here's how to navigate a tricky market when you have a shorter-term goal, according to investing experts.

The key to a successful short-term portfolio: balance

Successfully saving for a short-term goal comes down weighing three key factors, says Newcomb: "You'll have to find the balance between risk, return, and time horizon."

Say you're saving for a house and hope to save about $70,000 — equivalent to the traditional 20% down payment on a median-priced U.S. home. If you stash money you're saving under your mattress or plunk it in a short-term account such as a CD, which pays less than 1%, you're not only failing to earn much money toward your goal, but you're also effectively losing money because you're not earning enough on your cash to outpace the rate in inflation.

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"OK," you think. "I'll invest it in stocks." Not a bad idea, in theory. After all, stocks have historically provided compounding growth for investors and they could potentially help you reach your goal faster. But say you're just about to close on your dream home and the stock market falls into bear territory, defined as a 20% fall from recent highs, and something that happens not infrequently. Your $70,000 has quickly become $56,000, and your 20% down payment is now just 16%.

That's why, if you're saving for a goal that's less than a year away, experts recommend you go the proverbial piggy-bank route. "For ultra-short-term goals, the interest rate you earn is irrelevant," says Jamie Cox, managing partner for Harris Financial Group. "Treasury bills, cash, and CDs give you safety of principal. What's important is that your money is liquid and easily accessible."

For goals more than five years away, Cox says an equity portfolio is likely appropriate, given that you'll have time to bounce back from even a nasty bear market. For goals in between, however, you'll need to construct a portfolio that will do a better job than stocks of preserving your money when markets tumble but that provides more return potential to help you reach your goal than cash.

The trouble with bonds

Usually, the answer to this portfolio conundrum is simple: invest in what financial professionals call fixed income and what the rest of the world calls bonds.

"Traditionally, when you're saving for short-term goals, some level of fixed income is what you're looking for," says Cliff Hodge, chief investment officer for Cornerstone Wealth. "You get interest payments, less risk, and volatility isn't that much of an issue."

There's just one problem: These days, interest rates are super low. That means you'll earn practically nothing from the safest short-term bonds. Invest in a 3-year U.S. Treasury note (considered the safest kind of debt because it's backed by the U.S. government), and you'll earn a paltry 0.43% on your money. You won't do much better with high-quality corporate debt either. The Bloomberg Barclays 1-5 Year Corporate Bond Index currently yields 0.8%.

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That means that if you want to earn a respectable return on your bond portfolio, you'll have to take on more risk, says Hodge. "Now it's really about tradeoffs," he says. "How much risk are you willing to take on to get a little bit of extra return? There are no hard and fast answers."

Those tradeoffs Hodge references include higher yield "junk bonds," which offer juicier return potential than bonds with higher credit ratings but also carry a much higher risk of defaulting and tend to decline alongside stocks when markets slide. Or you might opt for bonds with a longer duration, which come with high yields but will fall in price should the Federal Reserve raise short-term interest rates.

Build the optimal short-term portfolio by spreading your risk

So in an environment where safe short-term bonds and cash pay practically  nothing and higher-paying bonds come with serious risks, what is the prudent short-term investor to do?

In short, spread the risk around.

One way to accomplish this is a sort of barbell approach that eschews bonds altogether in favor of cash and equities, says Cox — an especially prudent strategy, he says, if you believe interest rates are headed up. "If you maintain a large cash holding and interest rates start to rise, you're probably going to be just fine, but that would be negative to a bond portfolio, even if you're short on duration," he says. "I think cash is preferable."

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Cox suggests that someone with three years to invest and $100,000 in the bank could put $25,000 in a low-cost basket of dividend-paying stocks and keep the rest in cash. "That way, you spread the risk of that bucket of stocks across the entire portfolio," he says. "And having a cash strategy isn't an all or nothing proposition. If equities sell off, you can always use some of that money to buy at lower prices."

Newcomb points to a more broad-based approach based on portfolios constructed by Morningstar colleague Christine Benz, which prescribes an allocation of 20% to 40% to cash, 40% to 60% to high-quality short-term bonds, and 0% to 20% in longer-term bonds. By spreading your bets across different types of bond investments, you decrease the likelihood that any one of them will fall precipitously.

Buying an appropriate target-date fund, designed to mimic the allocation a retiree should have in a particular year, will give you a diversified portfolio in line with your time horizon, she notes.

The one move you'd be wise to avoid: Making short-term trades to try to optimize your returns. "At that point you're speculating, rather than investing," she says. "You're not looking to double your money with one of these strategies. And if you are, you're taking on a lot of risk I wouldn't recommend."

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