Given current market valuations and the pending interest rate movement, many investors are drawn to short-term investments. Fortunately for those looking to invest for the short-term, there are multiple options available.
What is a Short-Term Investment?
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Short-term investments are financial vehicles that can be easily converted to cash after a short amount of time, within 5 years, more commonly 3 to 12 months. Some options include:
- Treasury Bills (similarly, Notes and Bonds)
- Short-Term Bond funds
- Money Market funds
- High Yield Savings Accounts
- Short-Term Certificates of Deposits (CD)
Before choosing one or more of the above, consider the pros and cons of short-term investments.
Advantages of Short-Term Investments
Short-term investments have two distinct advantages over investments with longer time horizons.
1. High Liquidity
Short-term investments offer high liquidity.
Your bank’s savings account offers the greatest liquidity. With an ATM on every street corner, you can withdraw cash from a savings account at a moment’s notice. Recently, many online banks (e.g., Ally, American Express) offer slightly higher returns and it is worth a comparison.
Liquidity means money when you need it.
Similarly, Treasury bills and bonds are issued for terms of a certain number of weeks (4 – 52 weeks) or years but can be immediately traded for their fair market value (FMV). However, this trading is limited to hours of market operation.
Negligibly less liquid are Money Market and Bond Mutual funds. Relative to a savings account, mutual funds may require a business day or more to settle. This means a short waiting period is put between you and your money.
2. Low Volatility, Low Risk
Savings and money market accounts display minimal volatility. Cash deposits held in bank accounts are insured by the Federal government – up to certain limits.
This means that there is less risk of loss to your investment. (However, your money is still subject to purchasing-power risk.) Like a savings account, a certificate of deposit (CD) is stable in value. The exception is when investors forfeit a portion of interest earned for prematurely breaking the CD.
However, short-term bonds and bond funds are subject to fluctuations in value – albeit small changes. In a year of greater volatility, short term investments are an important component of a diversified portfolio.
Disadvantages of Short-Term Investments
1. Low Return
There is no such thing as a free lunch; in exchange for high liquidity and low volatility, short-term investments offer little in the way of investment return. In fact, most commercial banks offer practically nothing on savings accounts when interests rates are low, and don’t increase by much as interest rates climb. Investment custodians (Charles Schwab, Vanguard, etc.) similarly offer negligible returns on money market accounts.
Why is this problematic? When your investments generate a low-return, you run the risk of running out of money in retirement.
2. Tax Treatment
Most bond coupon payments and any interest payments are taxed at your marginal tax rate. (Certain municipal bonds are the exception.) This tax treatment is disadvantageous relative to the preferential tax treatment on certain dividends from domestic corporations, as well as the capital gains on long-term holdings.
Knowing both the advantages and disadvantages of short-term investing can help you decide how much of your assets you will invest for the short-term.
Editorial Note: This article was originally published in May of 2014. It has been updated for clarity and to reflect current data.