I have a multiple choice question for you:
You have some cash sitting in your bank account. You’re buying a house in 12 months and want to put 20% down so you’ll need the cash in a year. What should you do with the cash in the interim?
- Buy stocks. After all, stocks are up “yuge” over the last 12 months.
- Stocks might be a little risky, so invest the cash in bonds instead.
- Buy a 1-year CD.
- Leave the cash in your savings account.
cue the Jeopardy music….
I would accept answers #3 or #4. Although my preference would be for #4 given today’s extremely low interest rates. Let me explain.
I feel this is worth mentioning because several times over the last few months I’ve been asked something along the lines of, “Ken, I’ve got some cash set aside. I’ll need it in a year or so, but what can I do with it now to get a better return than what my bank is paying?”
In fact, most recently I had someone approach me about opening an investment account for cash that they were going to need in 6 months. As much as I want to grow my assets under management, I could never in good conscience invest cash that will be needed in six months. Why?
Because the asset must match the liability! A 6-month liability requires a 6-month or less asset. A stock is not a 6-month asset. What happens if within 6 months the market drops 10% (or worse)? You may not have time to recover that loss so the investment will be worth less when you actually need the cash. Imagine saving money for a down payment on a home next year, you’re all good to go, then you invest it in stocks and they lose 30% over that 12-month period. Now what are you going to do? Buy less house, take more debt and add mortgage insurance to your monthly payment, delay your home purchase, etc… At that point, it’s speculating not investing. And your spouse won’t be very happy when you tell them plans have changed.
In other words, time horizon is the most important factor when determining an investment strategy. If you have 40 years until you need to touch your money, you can afford to be very aggressive so go be unashamedly aggressive if you can tolerate the ride. If you have 3 months, however, then you must be extremely conservative (i.e. let the cash sit in your savings account). I wouldn’t even do a CD for 3-, 6-, or 12-months because it’s going to pay next to nothing and you’re giving up liquidity / access to that cash. The optionality of having access to your cash on demand is worth something. So with interest rates so low is that lost liquidity / optionality worth 0.5% interest?” Maybe not.
Keep this concept in mind for your college savings as well. Over the years, I’ve seen a lot of people who have done a wonderful job saving for their children’s college in a 529 account. Now the kids are a year or two from high school graduation and the college savings accounts are still invested as if the child was just entering pre-school. If your child is 16 that means those college savings may be withdrawn over the next six years. Therefore, the account should invested conservatively. After all, a six-year liability requires a six-year asset.