Investing with a medium-term timeline

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Investing with a medium-term timeline poses its specific challenges. The investment objectives (what the money is for) and time horizon (when you will need it) define the securities to be used. The investment plan should document the medium-term goals (like a new car, a home purchase, starting a business and education expenses for children) next to the long-term goals like retirement. The investor must understand his need, willingness and ability to take investment risk related to each specific goal and select the appropriate securities. Many will use the term "saving" instead of "investing" for anything which is not long-term investing.

Often investors will divide their investments in buckets according to the goals and timelines, and managing each with a specific strategy. Goals with a shorter timeline will require safer investing and should restrict investments to short-term instruments such as (high yield) savings accounts, bank CDs, money market funds, and short-term treasury securities that mature by the time the funds are needed. Longer term goals can include asset classes that fluctuate in price [1].

Overview

An investor would like to invest money for goals with a medium-term timeline in a vehicle with better return than cash to give this money a chance to grow without taking too much risk.

Goals with a medium-term timeline are very diverse;

  • Saving for regular/anticipated purchases that cannot easily be funded from cash flow: such as expenses for household appliances, new car, marriage, children.
  • Medium-term investing for specific projects that are some years away: like a down payment for a house or setting up a small business.
  • Saving for education: this is very specific; please refer to the pages in the education savings category on this wiki.
  • Saving for unanticipated needs for cash, such as medical bills or job loss is done via an emergency fund. The goal of the emergency fund is to provide a cushion of liquidity in the event of unexpected expenses or of a loss of regular income due to unemployment.

In setting the asset allocation (AA) and asset location for medium-term investing, the generic guidance of the Bogleheads® investing start-up kit and the Bogleheads® investment philosophy certainly applies if one correctly takes the need, willingness and ability to take risk into account. The specific characteristics of the security determines the suitability for the selected goal.

Elements to take into account when determining how to invest for medium-term

The characteristics of the project for which one is saving poses constraints on the investment. What is the need, willingness and ability to take risk on these medium-term timeline.

  • Is capital preservation mandatory? Or can the capital be put at risk to strive for higher return?
  • What flexibility is needed? How firm is the timetable of the project? Is it possible that the project needs to be initiated earlier than initially planned? Can the project be delayed if the investment does not have the necessary value at the target date, either due to lower return or loss of value? Can the project be put off until the investment recovers?
  • What is the savings rate, could one make up the shortfall before the target date if the value of the investment does not correspond to expectations?
  • What is your general approach to investing, what is your current asset allocation?
  • Particular tax considerations can also limit (or extend) the choices for the investment.

Saving/investing asset allocation options

One can distinguish classes of investment instruments suitable for the medium-term timeline. One should control the duration of the instruments to be in line with the due dates of the projects and ensure the quality is very high to avoid loss of principal.

  • Cash like: Very liquid and super easy to access, guarantee on the capital (if federally insured), lower return.
    Examples: Checking account, money market fund, (High Yield) (insured) savings account.[note 1]
  • Reward checking account [RCA] : somewhat higher return, if one is willing to put in the effort to set-up and maintain to get the higher APR.
  • Funds and ETFs: Longer timelines can be satisfied with safe (quality short-term) bond funds/ETFs, or even safe equity funds/ETFs if one can bear the risk. [note 2]

With respect to the timeline, it is advised to convert as the due date nears; from equity to bonds to safe fixed income instruments and finally cash. One can dollar cost average gradually to achieve this.

The options mentioned in the multi-tiered emergency fund can also be useful for medium-term investing.

Location options : taxable / tax advantaged accounts

General practice: use taxable accounts

Saving for short and medium term goals should be done in a taxable account (checking, savings, CDs,...). because taxable accounts do not have an annual contribution limits; they are refillable: take some money, put some money back, not a problem.

It is not recommended to save for known short or medium term needs/goals in a tax-advantaged account. Because such TA accounts have annual contribution limits. While it is possible to withdraw money under special considerations [note 3][note 4], they are not refillable, you can't put the money back after an early withdrawal. Your retirement growth potential is permanently harmed.

When to use tax advantaged account

On the other hand, it might be advantageous and possible to utilize non-used tax-advantaged space with extra contribution that have a medium-term timeline. This takes advantage of valuable Roth IRA contribution space that would be lost forever if you do not contribute. Compound interest requires time and money to work. Tax-advantaged space is better than taxable space. More tax-advantaged space is better than less, so use all you can every year. The advantageous is more likely if the mid-term goal is not certain. At the time of the purchase one would then retrieve the extra contributions[note 3]but not the earnings[note 4] from the account. (Please also read the description in the wiki page on Roth IRA as an emergency fund).

If you have a sizable taxable account, it is possible to place a cash needs requirement, such as a home down payment, in a tax-advantaged account and improve the overall tax efficiency of an investment portfolio.

See also

Notes

  1. This is Investopedia's definition of "Cash Investment": 1. Short-term obligations, usually fewer than 90 days, that provide a return in the form of interest payments. Cash investments generally offer a low return compared to other investments. They are also associated with very low levels of risk and are often FDIC-insured.
  2. White Coat Investor commented in the thread Buying a house in 2-4 years; what do I do with my mutual funds on the transfer from an existing investment in equity to a safer option for a house down payment:

    "The main thing is to consider your options in the event of a huge bear market. If the market drops 50%, what will you do? Here are some choices:

    1. Don't buy the house and just keep renting until the stocks recover and future savings gets you back to where you want to be.
    2. Maybe houses will be cheaper in an economic downturn and you can still buy it with your decreased amount.
    3. Maybe houses will be cheaper and you can use a mortgage with < 20% down, leaving your investments intact.
    4. Maybe you won't buy a house at all.

    For some people, for whom these options aren't good choices, should sell their stocks now and put the money in CDs. But there are many people for whom these other options are very realistic alternatives. For them, keeping some or all of the money in stocks is probably okay. The expected return is higher, even if the actual return may not be."

  3. 3.0 3.1 Contributions (that is, the money that you put into your Roth) can come out at any time, free of taxes and penalties. Gains are treated otherwise Roth IRA
  4. 4.0 4.1 Earnings of contributions withdrawn before the due date of that year will be taxed. See IRS Publication 590-B: Are Distributions Taxable?

References

External links

Boglehead forum discussions