When it comes to investing, your time horizon plays a huge role into what you actually invest in. Without taking into account your time horizon, you could end up investing in an asset that is too risky or one that carries too little risk and therefore won’t provide the return you need. In this post, I am going to focus on the various types of short term investments for you to invest in.
Appropriate Use Of Short Term Investments
Before we get into the various types of short term investments, we first need to understand when they make the most sense based on your time horizon. Below is a little chart for you reference:
From the chart you can see that if you have a short investment time horizon –you will need your money in less than 5 years – then you should be investing in cash and/or bonds.
Investing in stocks or equities at this point is not advisable since you would be risking losing your principal in return for a higher rate of return. This risk is simply too great and you should stick with cash and/or bonds.
Are Short Term Investments Safe?
The next question I get asked about the different types of short term investments is are they safe? For the most part, most of the types of short term investments are safe. Of course, if you listen to any sort of talk radio, there will be ads touting all sorts of safe types of short term investments, many of which are nowhere near safe and others even I haven’t heard of. Aside from these outliers, short term investments are safe? Of course, it does depend on your definition of safe.
Your Principal Is Safe
The overwhelming majority of times, when investing in checking, savings, and certificates of deposits, the principal you invest is 99.9% of the time safe. The only way you will lose your principal is if the bank where the investment is held at goes under and it wasn’t covered by FDIC insurance or you had more invested than the FDIC coverage amount allows. In this sense of the word “safe”, then yes, these are safe types of short term investments.
You Risk Losing Money
However, even though these are safe types of short term investments in the sense you will never lose principal, depending on the interest rate you are earning, you still risk losing money to inflation. I’ve talked before about inflation, but too many investors ignore it.
Over time, inflation eats away at the purchasing power of you money. We see this all the time. I remember as a kid a pack of gum costing me $0.50. Now it costs $0.99 if I am lucky. Most times is it more than $1. This is the effect inflation has on prices – it causes them to rise over time.
Historically, inflation runs between 2-3% annually. If your savings account earns you 1% per year, you are losing out to inflation. Let’s look at the numbers to see this in action.
Let’s say you have $1,000 and you invest in a savings account earning 1% annually and inflation is running at 3% annually.
After one year, you earned $10 in interest, making your investment worth $1,010. Because of inflation, an item that cost $1,000 when you started your investment now costs $1,030 at the end of the year. Your savings account investment is a safe type of investment in the sense that you didn’t lose your original $1,000 but your savings account is not a safe type of investment because inflation is outpacing your return.
While you eared $10 in interest, the cost of the item in question rose by $30, thus you “lost” $20 by having your money in a short term investment. Unfortunately, when we are in low yield environments like we are now, there isn’t much you can do about this. The good news is that interest rates won’t always be this low, so in time you should be able to keep up with inflation better.
High Yielding Safe Short Term Types of Investments
The next question you probably have is what are some safe, high yielding, short term types of investments to invest in? Unfortunately, there is no such thing, regardless of what the man on the radio or late night television is trying to sell you. Always remember that risk and return are related. The higher the risk, the higher the potential return you can expect. The lower the risk, the lower the potential return you can expect.
So what are your best options for short term investments that are safe?
Types Of Short Term Investments
OK, now that we know when you should be investing in short term investments, we can talk about the various types of short term investments. I will be listing these investments in order from lowest risk to highest risk. Understand that even though I say “highest risk” here, you can still safely invest in these investments for the short-term.
Cash: While keeping your cash under your mattress isn’t going to earn you any money, you can invest your cash into savings accounts. While interest rates are absurdly low today, you can still find some half decent yield on savings accounts.
One place to find a higher yield is to look online. Most internet banks offer interest rates closer to 1%. While this is still well below the inflation rate, it is better than what a brick-and-mortar bank offers.
If you are looking for a good online bank, Capital One 360 is one of the best. I’ve had an account with them for close to 10 years (earlier they were ING Direct) and have had nothing but great experiences with them. If you open an account with them using the link above with at least $250, you will get a $25 bonus. That is a 10% return right there!
Certificate of Deposits: Another option for your cash is to invest in a certificate of deposit (CD). The difference with a CD as opposed to a savings account is a higher yield. In return for this higher yield you have to lock your money up for a period of time.
With a savings account, you are free to take your money out of the account whenever you want. But with a CD, you have a period of time that you have to leave the money alone. You know the length of this period of time because you choose the term. Most common CD terms are 6 months, 1 year, 18 months, 2 years and 5 years.
The longer you lock your money up, the higher the interest rate you will earn. Of course, if you really need the money, you can still close the CD and get your money back. But in doing this, you will forfeit typically 3 months worth of interest payments. Note that there are some CDs that offer no penalty if you close the CD early, but they pay a slightly lower interest rate because of this.
Finally, there are some CDs that offer to increase your interest rate one time during the term. Since your interest rate is locked when you open the CD, you could lose out if interest rates rise. By letting you increase your rate one time, you can lower the chances of this risk.
Money Market Accounts: There are 2 types of Money market accounts. The first is virtually the same as a savings account. The only real differences are that you tend to need a higher balance in the account, you can write checks on the account and it carries a slightly higher interest rate.
The second type of a money market account is a money market mutual fund. These accounts invest in short-term bank instruments. The underlying value of the fund stays at $1 (although back in 2008 after the housing collapse, some funds did “break the buck”). Essentially, a money market mutual fund won’t lose your money for you and you will earn a little more interest than a basic savings account.
Short-Term Bonds: Short-term bonds are the riskiest of the types of short term investments that I list here. This is because this is the only investment that you can potentially lose your principal on.
While there are risks with short term bonds, they tend to pay a better interest rate than any of the other options listed. For those that are worried about losing principal, the value of short term bonds doesn’t fluctuate like stocks. If you look at a chart of most short term bond funds, you’ll see that they tend to trade in a small range. In other words, you might lose $0.50 or so per share you own.
Savings Bonds: Savings bonds are another short term investment option. Savings bonds are backed by the full faith and credit of the US Government and are therefore considered free of default risk. Currently there are two types of savings bonds available for purchase, the EE Series and I Series. The difference is how they pay interest.
- EE Series savings bonds pay a fixed rate of interest which is set when you purchase the bond, and remains constant for the life of the bond.
- The interest rate on an I Bond is made up of two components a fixed rate component and a floating rate component. The fixed rate component on an I Bond is set when the bond is purchased and remains constant for the life of the bond. The floating rate component is reset every 6 months based on the current level of inflation.
The current rate on an EE Series savings bond is .20%. There is an interesting feature of EE Series savings bonds however that not many people know about. If you hold an EE Bond for 20 years the government guarantees that it will at least double in value. That is a return of 3.5% over the life of the bond, which makes the EE series savings bond much more attractive than the 20 year US Treasury.
The current fixed rate component of the I Series savings bond is 0.0%. However the floating rate component is currently 1.76%. Keep in mind that the floating rate component will be reset every 6 months based on inflation, but can never go below 0%.
You can cash in a savings bond at anytime after holding the bond for 1 year. However if you cash the savings bond in before holding it for 5 years, then you have to give up 3 months worth of interest. After 5 years you can cash the bond in at anytime without penalty. Also keep in mind that an individual can purchase up to $10,000 worth of EE bonds and $10,000 worth of I bonds in any given year. Because of this, savings bonds make for good short term and long term investments.
Advantages And Disadvantages Of These Types Of Short Term Investments
Of course with any investment, there are advantages and disadvantages. This is true with the types of short term investments I list above.
As I mentioned before, for the most part, the major advantage of short term investments is retention of principal. In other words, you aren’t going to lose your principal in any of these investments (except for short term bonds). This is the major selling point of these investments and why you invest in them when you need quick access to your cash – you know that if you invest $10,000 you will always have your $10,000.
The major disadvantage of these investments again is the low yield or interest rate. When you take a small risk, as you do with short term investments, you are going to get a low return. In many cases, this isn’t the worst thing. Back in 2000, you could get 5% from an online savings account. But today, you are lucky to get 1%.
Overall, when it comes to the types of short term investments, you have a handful of choices. Currently, none of these investments pays well, but that is a price you have to pay. Don’t fall victim of taking on more risk just for a higher return if you need the money in less than 5 years. Trust me, the risk is not worth it. Accept that you are earning less interest and be done with it.
If you really want to get a little higher return, you can ladder your CD purchases to get a little higher return while at the same time controlling interest rate risk.