How should I invest for 3-7 years out?

Personal finance

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[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 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 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 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 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 (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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6 Feedbacks on "How should I invest for 3-7 years out?"

Larry Stay

My wife likes to organize like the author of the question. I am more like the author of the blog. Money is fungible and can be moved among your accounts with relatively low cost. Where you draw money from really should depend on your opportunity cost for loss of the return from the investment.

The 3 to 7 year term is a complicating factor. Usually for exposure to the stock market you want to have an investment horizon longer than the average business cycle so that you don’t have to liquidate the stocks in a down market. 3 years is too short, 5 to 7 years would be fine. The advice on index ETFs is very good advice. I strongly recommend this for most investors, and use them for all of my personal investments.

I manage bond portfolios professionally. Until very recently there have not been good options for retail investors to buy corporate bonds. Even now, the transaction costs are high. But, the discount brokers are making it easier and cheaper to pursue this option.

If you have access to Fidelity, Schwab, or other accounts, you may wish to search their sites for floating rate bonds. In a period of rising interest rates, these allow you to participate by resetting the coupon monthy or quarterly.

I would stick to bonds that mature in the 3 year range, so that you do not have too much exposure to spread duration (the risk that the average spread for corporate floating rate product increases, lowering the value of your bond.) Remember that when you buy a bond, you are effectively lending the company money. You want to be sure the company will be able to pay back the loan at maturity. Most retail investors probably want to stay with investment grade bonds and not high yield or junk bonds.

Good luck, and let me know if I can be of further help. I write an educational blog on investing that can be found at http://www.growyourfunds.com .



Ricemutt

Larry — thanks so much for your comments. I will definitely be visiting your site to learn more about bond funds, investing, etc. It’s so nice to have a blog around that’s written by a professional with credentials to match! (And yes, I realize this is a hypocritical statement, even though my experience is far, far less than yours.)



Responses to “How to invest for 3-7 years out” | Experiments in Finance

[…] Larry Stay from Grow Your Funds chose to leave his insights about choosing bonds in a comment on my response to the reader. He’s a professional bond portfolio manager with some nice credentials, and willing to take questions from readers about investing at his site, making it interactive. What a great resource! I’ve already learned about investment vehicles I didn’t even know existed. […]



TJ

Thanks, I appreciate all the input. I decided the first hurdle to clear was to set the money aside first, instead of waiting for a perfect solution to present itself. So I set up a new account for this today. Almost anything is going to be better than the 0.5% I’m getting from my savings account. :)



Narayanan Ravi

I am trying to learn about MFs. I would like to know, how I can go ahead in buying ETF. The broker I deal with doesn’t seem to interest me on it.
thanks
Ravi



Ricemutt

Hi Narayanan,

You shouldn’t need anything special to purchase an ETF. They are traded like just like any company stock and listed on the various US exchanges. There are several ways to learn more about what ETFs are available and which one(s) might be suitable for you.

One way is to go to Yahoo! Finance’s symbol lookup, select “ETFs” and then enter in a keyword (e.g. large-cap, energy, japan, etc.) that might describe what ETF you’re seeking.

There are also several “major” ETFs like iShares (Barclay’s) or Vipers (Vanguard), or S&P depository receipts like MDY and SPY. Those are probably the most well-known.

I hope this helps. I don’t know which brokerage firm you use, or if you have access to making trades yourself, but either way, if you’re able to purchase stocks, you should be able to purchase ETFs as well.

Thanks for your comment and question!



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