How should I invest for 3-7 years out?

[Note: This is my response to a question received from one of my readers. I’ve made it into a group writing project (instructions and original question are in the link). Please feel free to respond to the question and participate, and I will create a post linking to everyone’s responses this Friday. Thanks!]

Q: I like to setup my finances on a “purpose” basis. I create a separate account for each specific saving target. I have 401ks or IRAs devoted to long-term savings and a checking/savings account to handle day-to-day expenses. Some CDs as a safety net in case I lose my job. A separate savings account for spur-of-the-moment spending.

This keeps things tidy and reduces the tempation for my spur-of-the-moment spending and works great for short-term or long-term savings. But not so well for mid-term savings that are maybe 3-7 years out. I can’t figure out what the best vehicle is for carrying this out. I can take more risk (and want better return) than savings accounts and CDs, but it’s not so long that I want too much stock exposure. Any suggestions?

A: My approach to savings and investing is different from yours. I personally don’t like a proliferation of accounts, (although it seems inevitable since it seems every employer uses a different brokerage or investment company). However, I do share your concern of wanting to keep out temptation. Like most brokerage accounts, ours offers a link to a checking account, a credit card, and checks, and I politely decline all those avenues of withdrawal whenever they’re proffered. In truth, I also don’t invest based on well-defined time horizons but an ambiguous “long-term” outlook that definitely means at least a year, but usually longer.

If your question is whether there’s a single investment vehicle for the time period you’re looking for, the simple answer is no (as far as I know). My guess as to the easiest way to manage an account for 3-7 years is to open or use a brokerage account somewhere, deposit the money, and then put the money into a mix of bonds and index funds. At least, that’s the general gist and a conventional way of thinking that seems to work for most people. This is pretty much what I do, except for the bonds part. If you choose to go this route, here are a few tips:

1. If you don’t want 100% exposure to stocks, put in 50% or 75%, or whatever ratio you’re comfortable with.
2. If you’re like most people (myself included), you’re more likely to prefer and do better with passive investment. Don’t worry about trying to pick specific stocks. With the money you’ve decided to allocate to ‘stocks’ above, buy an index fund (a mutual fund), or, my advice, buy ETFs (exchange-traded funds) instead. There are several index ETFs out there (stock symbol ‘MDY” for midcaps, usually a good choice, and “SPY” for S&P 500, etc.), and their benefit is that they have lower management fees and costs than even mutual funds. All they do is track an index, so they’re as passive as it gets. Plus, as long as you don’t pick an illiquid (low-volume) ETF, you can get in and out of them quickly (should you ever need to), because they trade like stocks, and you aren’t subject to a short-term redemption fee. Some mutual funds penalize you if you withdraw money less than 180 days after you put it in, etc.
3. You can look into buying bonds with the remainder of your money. I’m not as familiar with this area, to be honest. I’ve looked into buying bond funds at several points, but I could never find one I was satisfied with; perhaps part of that is due to the selection of no-load, no-fee bond funds at my brokerage. There are also ETFs for bonds, but I didn’t like what I saw there, either: even though their underlying assets are bonds, they trade and behave like stocks, so I wasn’t sure that was a benefit in terms of diversification.
4. Instead, some people believe in buying US treasuries, which is as nearly risk-free as you can get. You can look into Treasury Direct to do this, and you don’t need to open a separate account to buy them. There are limitations as to how much you can buy, though, and as far as I can tell, the yield isn’t that much different from some savings accounts and CDs out there.
5. On the stock portion, to be entirely safe, you should probably consider dollar-cost averaging into the ETF or mutual fund you’ve chosen. This is a proven-to-be-successful tenet for buying stocks, which is a real rarity. Keep in mind that if you do this, you might be better off investing in a mutual fund rather than an ETF because most brokerages will require commissions for trading ETFs, whereas you may be able to regularly invest in no-load mutual funds without paying extra comissions, because most mutual funds are already set up for this type of regular investment. Still, you might want to calculate the fees on the index fund and weigh them against the trade commissions for buying an ETF. In my case, I found that the $10 per trade on an ETF easily outweigh the limited selection of no-load index funds that I have access to, and I’ve got the discipline to put regularly put in and calculate the # of shares to do this myself rather than use an automated system.
6. You might reconsider your thoughts on savings accounts and CDs — maybe don’t buy a multi-year CD, but a shorter-period CD that you can either roll into another one or decide to put it in stocks when it matures. The reason I mention this is that there’s been a lot of debate for a while now about risk premiums and how it might not really be worth investing in stocks these days when you can get such a high yield from MMFs, CDs, or savings accounts like Emigrant Direct (aff) at much less risk. For now, this is the avenue I use lieu of buying bonds.

I guess the short of it is that I can’t think of a single vehicle that will do what you’re looking for, but hopefully this has given you a few ideas to play with. Thanks for your question!

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