A reader recently asked me whether the stock market was a good place for money that she plans to spend in 3-5 years. Her reasoning was that–while 3-5 years is generally too short a time for the stock market to be a safe investment–perhaps the fact that the market has gone down so far already means that the next 3-5 years are more likely to be good ones.
On the one hand, that makes intuitive sense. Down markets must be followed by up markets. The catch is that it’s hard (impossible, even) to know exactly how long the down market will last. Bad Money Advice phrased it well recently:
People tend to expect a V pattern in stock prices, that a few really bad years are inevitably followed by a few really good years. The stock market doesn’t work that way. It can’t. It’s like a law of nature. The market cannot let itself be so easily predicted. Knowing what happened one year tells you (almost) nothing about what will happen the next.
Exactly. Everything I’ve read and experienced personally leads me to believe that over short periods, the market is truly unpredictable, not “unpredictable most of the time.”
In other words, I’m not saying that I don’t expect the market to rebound within the next 3-5 years. I’m simply saying that–if I’m completely honest–I have to admit that I have absolutely no idea how long it will take for the market to come back. As such, the only investment strategies I can recommend are ones that can accommodate this lack of certainty.
So what should she do with the money?
CDs and high-yield savings accounts are obviously decent options in this case. Or perhaps a combination of those and a no-load, low-cost bond fund.
Alternatively, I could see the wisdom of allocating a small portion of the portfolio to the stock market, while keeping the rest in investments with very little volatility. Note: the wisdom of this plan depends significantly on how likely it is that the time frame will be closer to 5 years than to 3 years.
What do you think? What would you do with money that has a 3-5 year time frame?
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{ 5 comments… read them below or add one }
What about this?
30%: Short-term corporate bonds
30%: Inter-term corporates
40%: Balanced index (40% total bond index, 60% total stock index).
The net allocation is thus: ~75% bond, ~25% stock.
There is some volatility in bonds, so keep your 1-2 year money in CDs or liquid, high-rate savings accounts or (insured) money market accounts.
If you want to be reasonably sure you won’t lose money over any 3-5 year period, your best choice is to have 0-10% in stocks (a diversified portfolio) and the rest in an equal split of short-term and intermediate-term bonds.
Mike, if you remember my posts on diversified portfolios in December, one of the things I looked at is how often the portfolios would lose money over different time periods. A 100% bond portfolio never lost money over any 3 year period since 1927, and a 90% bond portfolio (10% stocks) never lost money over any 5 year period since 1927. During any consecutive 3 years from 1927 to 2007, the 10% stock portfolio lost money 2 times out of a possible 79 periods. The two worst 3 year periods were 1929-1931 and 1930-1932, when the portfolio lost about 2.7% and 0.3% of its original value, respectively.
So I agree with you, for money you’ll need in 3-5 years you should only put a small portion in stocks (<10%). The rest could be easily split between a short-term and intermediate-term bond fund (Vanguard has one for each).
I would suggest a 3 year CD. This will lock up the money and the user won’t be tempted to use it for anything.
But if we want to play around a bit with markets, perhaps a target 2010 ETF or mutual fund.
Thanks to all three of you for contributing suggestions. It looks like–while the specifics varied somewhat–we’re all on a similar page here: Keep stock exposure to a minimum.
If you need that money to spend, then you are better off staying away from the market is what I’d think.