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The ABCs of Investing: Managing Short- and Medium-Term Funds

September 2007

Piggy Bank

With the markets in turmoil, plenty of investors are worried. If the money you need to pay your son’s college tuition bill is in the stock market and he’s off to college next week, then you should be very worried, but if your stock investments are mostly in your 401(k) and you won’t be retiring for another 20 years then you can sleep easy.

The first step in planning your investments is to ask yourself how much do I need and when do I need it? Once you know when you need the money, you’ll know whether or not it should be invested in stocks.

Three Tiers of Savings

The Motley Fool suggests that you visualize your savings as a three-layered wedding cake:

“To put your short-term savings into context, think of your finances as a wedding cake. The bottom layer is your long-term savings. The goal is to compound that long-term money into a wide, deep foundation of your finances. Ideally, it will eventually be the biggest piece of your cake, broad enough to support a long and active retirement. Stocks are ideal for this. Being the bottom of the cake, it is the least accessible. Leave it alone until the proper time has come; otherwise, your cake will crumble.

“…[The next layer is your] big-ticket fund, [money] you plan to spend within about five years. It might be five years’ worth of living expenses if you are already retired, a college fund if you have older kids, or a house down payment. This is also where you stash money earmarked for the new roof, new car, or even a major vacation. CDs or short-term bonds can be used for these predictable expenses. Being the middle tier, it should be accessible sooner than the stuff in the bottom layer, but not until the proper time.

“The top tier of the cake is your rainy day fund, your peace-of-mind money. It’s there for medical emergencies, car-repair emergencies, pink-slip emergencies. Think of it as the credit card-avoidance fund, if you like.”

Building Your Rainy Day Fund

To figure out how much money you should keep in your rainy day fund, sit down with your checkbook and credit card statements for the last year and figure out how much your family spent on “no-choice-about-it,” day-to-day stuff like your mortgage, medical insurance, food and heating bills (category A). Computer programs like Quicken can help with this, but if you don’t like fiddling with computers they can keep you from getting started. Paper, pencil and a calculator can get the job done, too. Most financial planners advise that your rainy day fund should hold enough money to fund three to six months of category A day-to-day expenses, to tide you over in case of job loss or illness.

Also figure out roughly how much you spent last year on stuff that’s not so essential, like vacation and holiday gift spending (category B), and make a note of recurring hard-to-predict expenses, like car and home repairs (category C).

Many advisers also recommend that you add onto your rainy day fund enough money to cover a typical year’s worth of category B and C spending. You can dip into this savings pool any time you need to, rather than relying on credit cards to fund that vacation or car repair. Just remember to keep replenishing your rainy day fund, so it’s there when you need it.

Your rainy day account is an example of a short-term savings pool—money that you might need within a one-year period. For such short-term funds, the top priority is keeping the money really safe and available at a moment’s notice. While stocks are one of the best long-term investments, over a one-year period you have about a 30 percent chance of losing a lot of money. Even long-term bonds can lose value in the course of a year. You need a safer place for your short-term funds. What’s ideal? Bank checking and savings accounts, money market funds held in a taxable brokerage account, short-term (<3–6 month) CDs and short-term Treasury bills are all examples of good places to invest short-term funds.

Building Your Big Ticket Fund

Your Big Ticket Fund is for money you are pretty sure you will need within the next five years. It might be five years’ worth of living expenses if you are already retired, a college fund if you have older kids, or a house down payment. This is also where you stash money earmarked for the new roof, new car, or even a major vacation. The tricky part here is being imaginative enough to budget five years out into the future. Start by daydreaming, with a pencil and paper in hand. What will my life be like in five years? What might change, what might stay the same? Do I plan to buy a house? Am I about ready to retire? Take a sabbatical and travel around the world? Try grouping each of these daydreams; some will be dreams that you might want very much, but that don’t qualify as an absolute necessity. In other cases the expenses you may face are true obligations: a likely need to care for a disabled parent or help a child finance his college education, for example.

Next you’ll need to do some research. How much will that first home really cost? Can some of the increased expenses be paid by salary? Any shortfall is how much you ought to have in your Big Ticket Fund. Focusing on “the bottom line” can help you distinguish between true needs and those daydreams that are best deferred or trimmed down a bit, and it can give you the extra incentive you need to get your current spending under control now, so you’ll have more flexibility in the future.

Investing Your Big Ticket Funds

In reaching for those wilder daydreams, you might be tempted to make your money “work” harder and “play” the stock market or “invest” in high-yield debt to try and make your dream possible. But that can be a recipe for financial disaster—one that might compromise not only your dreams, but even your ability to meet genuine obligations. The basic rule is that money you know you will need in five years should not be in the stock market. Here’s data from Ibbotson Associates that shows why:

Your Big Ticket Fund needs to be safe, but need not be as readily available as short-term Rainy Day funds—and in fact it often pays to lock up these funds so you will be less tempted to blow the whole thing on designer shoes. US Treasury notes with 2-, 3- and 5-year maturities and FDIC insured bank CDs (Certificates of Deposit) are excellent medium-term investments. Your medium-term funds need to be “laddered.” Laddering minimizes interest rate risk and maximizes your return. When constructing a ladder of CDs and bonds, it’s important to keep your five-year spending plan in mind so that you match the point at which your CDs and notes or bonds mature with the date on which you’ll be needing the money. Here’s a great primer from Charles Schwab on how to ladder bonds.

Financial Coaching can help you sort out the daydreams and the realities of your family finances. Coaching can also help you get motivated and stay on track when you need to make life changes. To learn more about how financial coaching can help you, schedule a free initial consultation.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Past results are not indicative of future performance. Outside sources used in this article are believed but not guaranteed to be accurate. Examples provided are for illustrative purposes only and are not representative of intended results that a client should expect to achieve.