It’s a common problem.

You’ve got some cash in a savings account earning a paltry 0.01%. You plan to spend it to buy a home or a car or something else in a few years. How can you invest the money until then to earn some extra interest?

It’s called short term investing and it’s tricky. Put your money in the stock market and it could be gone when you need it. Put it in a traditional savings account and it earns practically nothing. So, what should you do?

Recently, a listener to our podcast, Michael, emailed me with just this dilemma:

Hey, Rob. I wanted to get your thoughts or maybe you could point me to a podcast. I am currently in the oil industry and have survived the layoffs at my company. It looks as if things are turning around. Over the past two years I’ve stacked up some cash in my Ally Bank savings account at one percent interest. I don’t currently need the cash at this moment but could need the cash within the next year or two in order to purchase land for my family. If I wanted to invest the cash but be able to have it back in one way or another within two years, what is the best way to go about this? A brokerage account which we currently own? I know there are short and long-term capital gains which might still outgain a one percent interest but I’m just curious on your thoughts.

Let’s answer Michael’s question.

Listen to the podcast on this topic:

What is a Short Term Investment?

What exactly is a short term investment?  Well, there is no official definition. There is no governing body that defines what short-term or long-term investing is. It’s arbitrary.

For me, short-term investing is investing money you’re going to need to spend in fewer than five years.

Why five years? Because most of the time, the stock market doesn’t lose money over a 5-year period. It can, of course. Go back to the 1930s and 40s and you’ll find 5-year periods where the market was crushed, as this Bankrate slideshow demonstrates… 1932 was the worst. The 5-year period ending that year saw a drop of 60.9%.

But that’s rare.

When we have a pretty significant stock market correction or a bear market, it usually takes us at least five years to pull out of it. Of course, that’s not a guarantee. We could hit a bear market and it could take us 10 years to pull out of it.

Either way, five years is where I draw the line. You may want to draw your own line more conservatively… or even less conservatively, for that matter. What I hope to do today is give you some information that will enable you to make a sound decision.

So, let’s begin.

The 9 Best Short Term Investments

1. Online Savings Account

Traditional banks pay as little as 0.01% on a savings account. That’s as close to zero percent as you can get.

One option for short-term savings that pay more is to go with an online bank. While the rates are still nothing to brag about, the top online savings accounts today pay about 1.05%. You can see the top current rates here.

Pros

• FDIC insured
• Funds can be withdrawn at any time
• Rates better than a brick and mortar bank
• No fees

Cons

• Interest rates are still low
• Inflation exceeds the rates

Expected Annual Return: 1.05%

2. Certificate of Deposit

The second option for short-term money is a certificate of deposit. CDs give us a lot more options than a savings account. The term of a CD can range from a few months to more than five years, and the longer the term, the higher the rates.

These higher rates, however, come with added risk. Here’s why.

A CD can be cashed in before it matures. For example, you could invest in a 5-year CD, but decided to withdraw your money after the first year. If this happens, however, most CDs charge a penalty. The amount of the penalty varies by bank and CD product.

As a result, it’s best to keep money in a CD until it matures. For this reason, picking the length of the CD is a critical decision.

So, you end up having this delicate dance—you want a long CD term so that you can make the most interest. But you don’t want to pay a penalty if you take the money out early.

Pros

• FDIC insured
• CD terms ranging from 6 months to 5 years or longer
• Higher interest rates on longer term CDs
• Can create a CD ladder

Cons

• Still relatively low interest rates
• Penalty for early withdrawal

Expected Annual Return: 1.00 to 2.50%

Here is a list of banks that offer high-yield CD options:

3. Short Term Bonds

Our third option is short or intermediate term bond funds. More specifically, we want to look at low-cost index mutual funds and ETFs. Both Vanguard and Fidelity offer several options.

Here, you have some important choices to make. Do you want a fund that invests just in U.S. government bonds or one that also invests in corporate bonds? Do you want a short-term bond fund or an intermediate-term bond fund?

Like everything else in life, these choices involve trade-offs.

U.S. Government bonds are more secure than corporate bonds, but they pay less. Short-term bonds are less sensitive to interest rate fluctuations than intermediate-term bonds, but they pay less. Today, short-term government bonds do not pay much more than an online savings account. For example, the SEC yield on Vanguard’s short-term Treasury fund is just 1.25%.

For my money, I want to do better than that in a bond fund. While intermediate term funds can lose money in a given year, they are reasonably stable. Vanguard’s Intermediate-Term Bond Index Fund (VBILX), for instance, costs just 0.07% and sports an SEC yield of over 2.50%.

A review of the performance of VBILX shows that it lost money in only one of the past ten years:

Pros

• While not FDIC-insured, still reasonably secure
• Intermediate-term bonds can yield significantly higher rates than a savings account
• Money can be withdrawn from the fund when needed

Cons

• Not FDIC-insured
• Can lose money
• Rates are historically low

Expected Annual Return: 1.00 to 6.00%

4. Bulletshares

There is a downside to traditional bond funds. They can experience capital losses as funds sell some bonds to buy new ones. If interest rates have risen, the fund incurs a loss on the sale of bonds.

Enter Guggenheim’s Bulletshares. These ETFs combine the potential returns of a bond fund with the fixed maturity of a CD.

Traditional bond funds continue in perpetuity. The fund management regularly sells bonds as maturities age and replace them with new bonds with longer maturities. In contrast, Bulletshares have a defined term of one to ten years.

At the end of the term, assets are returned to existing shareholders. And unlike CDs, a shareholder can sell his or her ETF shares at any time without penalty.

Related: How to Limit Taxes from ETFs

Bulletshares come in two flavors: (1) corporate bonds and (2) high-yield corporate bonds. The first invests in investment grade corporate bonds. The second buys bonds issued by corporations with a credit rating below investment grade. It involves more risk but offers higher returns.

As an example, the Guggenheim BulletShares 2020 High Yield Corporate Bond ETF has a current yield to maturity of over 5%.

Pros

• Potential for higher returns
• ETF shares can be sold at any time
• Fixed maturity dates

Cons

• Not FDIC-insured
• Funds can lose money

Expected Annual Return: 1.50 to 5.50%

5. Municipal Bonds

There is a significant downside to bonds: taxes. Interest earned on bonds is taxed, as are any capital gains.

One option to reduce the tax burden is municipal bonds (known as “munis”). These bonds are typically free of federal income tax and may be free from state income tax, too. Munis are an excellent option for those in the higher federal tax brackets.

I’ve invested in Vanguard’s Intermediate-Term Tax-Exempt Fund (VWIUX) in the past. SEC yields on these funds are lower than similar taxable bonds. The comparison must be made on an after-tax basis. This fund currently sports an SEC yield of almost 2%.

Pros

• Potential for higher returns
• Tax advantages
• Easy access to funds without penalty

Cons

• Potential for losses
• Not ideal for those in lower tax brackets

Expected Annual Return: 2 to 5% (after tax)

6. Betterment

Betterment presents an interesting opportunity for short-term investors. It’s not an investment. Rather, it’s an online company that makes investing in stock and bond ETFs easy.

The service can be used for all types of investing, including long-term retirement investing. To use Betterment in the shorter term, you must get the asset allocation right.

Learn More: The Perfect Asset Allocation Plan

Betterment lets investors decide how much to put in stock ETFs and how much to put in bond ETFs. For short-term investing, a 50/50 allocation protects against the downside while allowing for potentially higher returns.

Here’s the 50/50 asset allocation with Betterment:

The 50% in stocks gives us a chance to earn greater returns. The 50% in bonds helps protect short-term investors from a market crash.

There are no guarantees, of course. But looking at a 50/50 portfolio during the 2008-2009 market crash gives us some comfort.

Using PortfolioAnalyzer, I assumed we invested $10,000 at the start of 2008. Assuming we needed the money three years later, how would our 50/50 portfolio perform over a 3-year period. Remember that in 2008, a total U.S. stock index fund lost more than 37%.

Here are the backtested results of our 50/50 portfolio:

The portfolio still lost money in 2008, although far less than the 37% that the market dropped. And what was our final portfolio value at the end of 2010? It grew to $11,014, for an annual return of 3.27%.

While 3.27% is not a great return, remember that 2008 was a very bad year for stocks. Shift our time period one year forward (2009-2011) and our annual return jumps nearly 11%.

As a result, a 50/50 portfolio with Betterment is a reasonable choice for those needing the money in three to five years.

Pros

• Very easy to implement
• Money can be withdrawn at any time
• Potential for much higher returns
• Fees are very low

Cons

• Not FDIC-insured
• Potential for capital losses

Expected Annual Return: 0 to 10+%

7. Lending Club

Lending Club offers another option with the potential for better returns. This P2P lending platform makes it easy to invest in loans to individuals and companies.

It’s also perfect for short-term lending. Loans on the platform are for either three or five years. If you know you won’t need the money until then, Lending Club is a reasonable alternative.

I’ve invested in Lending Club loans since the platform was first launched. My current annualized return, including loans that defaulted, is over 8%.

With higher returns, however, comes higher risks. Loans do go into collection and eventual default from time to time. Over the years, I’ve invested in 17 loans that defaulted.

The key is diversity. You can invest in a loan with as little as $25. By diversifying across many loans, you minimize the effect a single default will have on your portfolio.

Pros

• Very easy to invest in a diversified loan portfolio
• Potential for high returns on a short-term basis

Cons

• Not FDIC-insured
• Cannot liquidate the loans early
• Potential for losses

Expected Annual Return:  5.00 to 7.00+%

8. Wealthfront

Like Betterment, Wealthfront is a robo-advisor that makes investing easy. I list it here in addition to Betterment for one reason: It’s free.

Well, it’s free for your first $10,000. After that, the cost is similar to Betterment. For both, you pay the very low fees charged by the ETFs. You also pay a Betterment or Wealthfront fee of about 25 basis points.

With Wealthfront, however, the 25 basis point fee is waived for the first $10,000.

Pros

• Very easy to implement
• Money can be withdrawn at any time
• Potential for much higher returns
• Fees are very low

Cons

• Not FDIC-insured
• Potential for capital losses

Expected Annual Return:  0 to 10%

9. SmartyPig

The final investment option on our list offers an interesting twist to online savings accounts. SmartyPig combines a high-yield with savings goals.

First, the high yield.

As you’ll see below, SmartyPig tends to offer rates higher than even most online banks:

Now, the savings goals.

With SmartyPig, you set specific savings goals. You can set multiple goals, or just one. You then add to the account until you reach your goal. In this way, SmartyPig is ideal for short-term savers.

Related: How to Establish Financial Goals

Pros

• FDIC-insured
• Potential for returns higher than most online banks
• Makes saving for a specific goal very easy

Cons

• Low rate compared to other options

Expected Annual Return: 1.00+% (depending on account balance)

Is the Stock Market a Good Place for Short Term Investing?

We could stop here. After all, the above short-term investing options should cover most situations. Yet. there remains one question that many ask.

Why not just put all our money in the stock market?

It’s an understandable question. Particularly when the market is rising, missing out on money can be painful. It’s funny, though. Nobody asks me this question in a bear market.

And that’s the point. With the stock market, you can lose money over a short period of time.

Thinking Long Term: Sweat In Up Markets So You Don’t Bleed In Down Markets

Let’s return to 2007 and run a test. We’ll use the Vanguard S&P 500 index fund as a proxy for the market. And we’ll assume we have $10,000 at the start of 2007, that we’ll need to use in three to five years.

How would a $10,00o investment have performed? At the end of three years, we would have $8,395, for an annual return of -5.66%. At the end of five years, we would have $9,837, for an annual return of -0.33%

Yes, 2008 was a bad year. But again, that’s the point. Investing 100% of short-term money in the stock market presents a significant risk of loss of capital. Fortunately, we have better ways to invest for the short-term.

Happy investing!

Topics: Investing

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