A reader asks:
I’m guessing that five years from now I’ll need to replace both my roof and my car. I would like to have $100,000 set aside for these expenses. Five years of experience looks like an investment on nobody’s land. Stocks appear to be a bit risky over that time frame, and higher interest savings, while attractive now, will likely lead to a drop in rates if the Fed cuts interest rates in the future. I’ve also considered doing something like a target date fund and managing the stock and bond allocation through a robo advisor, which would reduce the risk over time. I am planning to dollar cost average over the next five years as I have the money available for savings. Do you have any suggestions on how to allocate savings over this time frame? Are there other options that I should consider?
If we were considering a lump sum amount then the answer would still be very simple. Put your money in a 5-year US Treasury bond yielding 4.5% or thereabouts, and defer it for a day. This is a very good return with an exact matching of asset-liability for the future.
The fact that you will be saving money periodically till you reach your goal changes the equation a bit but we are more inclined to think of investing in the stock market for such an intermediate term goal. Can still use that 5 year time horizon.
Here are the 5-year total returns of the S&P 500 since 1926:
And here’s another way to look at these returns, ranked from worst to best:
The good news is that most of the time stocks have been up on a 5-year basis. Returns were positive in 88% of all current 5-year windows.1
The bad news is that the range of returns from good to bad has been quite wide:
- Worst 5 year return: -61%
- Best 5 Year Returns: +367%
To be fair, both of these 5-year windows occurred in the 1930s, but if we look at the post-World War II data, there is still the potential for a wide range of outcomes:
- Worst 5 year return: -29%
- Best 5 year return: +267%
I have a relatively high tolerance for risk. But if I am investing for some specific goal in future and I know how much I will need and when I will spend the money then stock market is too risky for me unless we are talking about 5+ Have been year or so.
And since you’re going to be saving this money over time, the stock market gets even riskier as you approach the deadline to spend on that new roof and car. Here are the historical win rates for US stocks over 1, 2, 3, 4 and 5 year periods:
The odds are still in your favor but the range of results and the potential for loss increase the shorter your time frame is:
If you can count on those average returns year after year then you’ll be all set, but there’s a risk of seeing losses right when you need your cash, which doesn’t sound attractive. This is an unnecessary level of financial stress in your life.
The idea of using a target date fund or robo-advisor makes more sense than putting all your money in stocks because you have the ability to diversify and have some say over your risk tolerance and the timing of that target.
The Vanguard 2030 TargetDate Fund currently consists of 65% stocks and 35% bonds. The 2025 fund is like 60/40.
Some people have a higher risk appetite than I do when it comes to these things, but if I had a goal like this, I wouldn’t make it more complicated. Just look at the rates you can lock in on short-term Treasuries right now:
Can rates fall again? Sure. That’s a strong possibility in the coming years, but now you have the ability to lock in higher rates for longer periods of time, as the longer end of the curve is gaining momentum.
I have 3 simple rules when it comes to short to medium term financial goals:
1. It must be liquid.
2. I am not ready to accept more volatility.
3. I don’t want the potential for a big loss when I need to spend it.
You can earn more money by investing your savings in riskier securities. But the downside of having less than you need when the bills come due far outweighs any added benefit from taking on more risk.
We discussed this very question in the latest edition of Ask the Compound:
Kevin Young joins me on the show again today to talk about early retirement, spending money on your financial goals, consolidating multiple HSAs and questions about how to pay for your home renovations.
Further reading:
roll the dice in the stock market
1As always, I’m using monthly total return (with dividends) for these performance numbers.
2 I have used the simple arithmetic mean here, not the geometric mean, for scoring the quantities at home.
Source: awealthofcommonsense.com
