The primary benefit of short-term investments for a diversified portfolio is their liquidity, or how readily they can be converted into cash. In other words, short-term investments can add a degree of flexibility to your portfolio while retaining the potential for gains.
Generally speaking, investors consider short term investment as an investment with a duration of three months up to five years. Best-known examples of short-term investments include CDs, money market accounts, high-yield savings accounts, government bonds and Treasury bills. These assets typically allow you to keep cash relatively close at hand, while earning a better return than you’ll see from a traditional savings account.
As we indicated above, many short-term investments work like savings accounts, that can provide a predictable return over a given period of time — typically five years or less. The interest bearing accounts comprising this asset class are lower risk, as you’ll buy them knowing the amount of the return you’ll expect to gain over a predetermined time horizon.
This makes short-term investing ideal for potentially fulfilling savings goals, such as planning for a dream vacation, a wedding, home renovations, or even the cash purchase of a new car. Planning ahead and saving for these things lets you enjoy them without potentially taking on debt.
In fact, rather than paying interest to finance these purchases on credit, your money will earn interest to help defray the eventual costs. Meanwhile, long-term investments such as stocks — while offering the potential for higher rates of return — come with the risk of realizing no return at all. An unfortunately timed market dip could wipe out gains when you need them the most.
In a nutshell, short-term investment strategies can offer low returns in exchange for less risk, while long-term investments offer a higher return in exchange for your willingness to take on more risk.
It’s useful to think in terms of time horizons when considering short-term investment options to diversify your portfolio. The farther out you’re willing to go, the greater the return you can derive from the investment — in most cases. With that in mind let’s take a look at some short-term investments from the perspective of duration vs. reward.
Two Years or Less: An online savings account, money market account or cash management account will potentially serve you for money you’ll need in two years or less. Yes, these are low risk, low reward assets. However, if you know you’re going to need access to that cash within two years or less, these are smart plays.
You’ll see a return of 0.5% on average, which compares rather favorably to the 0.06% you’ll see on a basic savings account, according to the FDIC. Speaking of which, these investment products are guaranteed by the FDIC up to $250,000.
Two to Three Years: Short-term bond funds and money market mutual funds may be your best approach if your savings goal is three years distant. These assets represent what many see as moderate risk while returning what could best be considered a medium reward.
You can see between 1% and 2% — sometimes a bit more.
Bonds are essentially loans you make to a company or a governmental agency based upon the promise of a fixed rate of return. While safer than stocks, they do still entail a degree of risk where lending to companies is concerned. After all, a company could face hard times and declare bankruptcy.
Government bonds, on the other hand, represent a safer play, as governments usually don’t go out of business. Short-term bond exchange traded funds (ETFs) are another good entrée to this investment option, as they can also help you add more income while meeting short-term investment goals.
Money market mutual funds purchase short-term debt from the U.S. government, municipalities and corporations. A key advantage of this investment vehicle is the potential tax advantages, as municipal securities are usually tax-free. On the other hand, there is no FDIC protection should one of these investments go awry.
Three to Five Years: Bank certificates of deposit (CDs) can bring returns from 0.75% up to 1%, while peer-to-peer loans can net you 5% or more over that same time period. When it comes to a use for cash you’re certain you won’t need for a while, CDs are a good way to earn interest on it with little risk.
Moreover, the longer the term you agree to take on as an investor, the higher the interest rate you’ll likely command. Generally speaking, the term of a CD will run from three to five years. Keep in mind though; you’ll incur an interest penalty ranging from three to six months of accumulation if you access the money before the certificate matures.
Among the riskiest of short-term investments, peer-to-peer loans consequently have the best return potential. While predicting future performance is always difficult, gains of 5% or greater are quite common.
These loans are typically facilitated through online platforms and borrowers are classified by their credit histories. This serves to minimize the risk if you choose to lend only to borrowers in the top credit tiers. However, you’ll see less of a return on borrowers in that category — usually in the 3% range.
One of the most attractive alternative short-term investments is the short-term note. These offer the opportunity to earn interest over the course of a 120 or 180-day term. You’ll receive monthly interest payments at an annualized interest rate and your principal is returned at the note’s maturity, or you can roll it into another investment.
Delivering interest rates higher than most CDs, Yieldstreet’s short-term notes are one example of an alternative short-term investment. These notes offer liquidity in as little as six months along with rolling maturities. They are fee-free, with no expenses charged against them.
Yes, there is a risk the investment could fail, as these issues are not FDIC protected. Moreover, as with other investment opportunities, some investments financed via Yieldstreet’s short term notes may have senior lenders who would receive first payment in case of default. However Yieldstreet does generally hold a percentage of the notes issued in each series in a first loss position to protect its investors.
The most significant risk (or disadvantage, if you will) associated with short-term investments is the opportunity cost.The difference between what you realize from a short-term investment and what you could have harvested from a long-term vehicle is the cost of the short-term investment.
In an interview with Forbes, Todd Soltow, co-founder of Frontier Wealth Management, in Houston, Texas explained opportunity cost thusly; “In economics, opportunity cost equals the expected return on the Forgone Investment Option (FO) minus the expected return on the Chosen Investment Option (CO).” Simply put, the opportunity cost formula is: Opportunity Cost = Forgone Option – Chosen Option
Of course, all of this is moot if the specific purpose of your short-term investment is parking some cash for an upcoming expenditure, while realizing some growth from it in the interim. The short-term investment can best serve your specific need in that regard; therefore the opportunity cost is irrelevant. Beyond that, the nature of the risk varies with the type of short-term investment you make as outlined above.
And, of course there are always taxes to consider. Regardless of the type of short-term investment you choose, taxes will be an issue (with but few exceptions as also noted above). In most cases, interest earned on these investments is taxed at the same rate as your ordinary income.
When it comes to short-term investments for a diversified portfolio, it’s important to remember the products you choose should be based upon your overall goals, both for your money in the short term and the diversification of your portfolio overall.
In other words, this is anything but a one-size-fits-all proposition.
Generally speaking, if you’re looking to invest money for the short term, you’re probably trying to find the safest place to put some money to work before you need to use it in the not-so-distant future. In other words, along with potential gains, you’re looking to have ready access to the cash invested when the need arises.
The best way to approach this is to think in terms of time increments. What will you need to do in three months and how much money will you need to do it?
The best short-term investment for you in each instance will be the one that offers the most significant gain, over a prescribed time period, at minimal risk. The options listed above can help you achieve those goals, while keeping your cash as liquid as possible.
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