Lisa Whitley — I actually don’t believe that the most common investing question is “How do I invest for retirement?”Nor is it “How can I get a high return on my emergency fund?”(You know you can’t, but thank you for asking.)I believe that the question most asked is “What do I do with money that I don’t want to invest for retirement, but I won’t need anytime soon?”
Let’s talk about risk. In our scenario, you are saving for a goal that is several years away, perhaps 5 years or more. But that goal is very, very important to you. So while you are comfortable with the idea of taking on some risk to the amount of return you could earn, you are not willing to take much risk to actually having your money returned to you. If the value of your investment did not grow as much as you had hoped during those 5 years, you may be willing to push that goal back to year 6 or 7, or perhaps downsize the purchase that you have in mind to match what you have earned on the investment. Perhaps that midterm goal is a house down payment, graduate school tuition or even a round-the-world travel sabbatical.
In that scenario, you may want to consider investing in a high quality bond index mutual fund or exchange traded fund — ETF.(Note: You can buy individual bonds directly, but that is usually impractical and not well-suited to funding a goal incrementally over a period of time.) “High quality” means that the fund holds bonds that are rated no less than “AA”, generally US government bonds and bonds issued by the largest corporations. The rate of return on the bond fund investment will almost certainly be less than if you invested in a stock mutual fund, but you can pretty much depend upon getting back at least what you put in within your medium-length time frame.And you will likely favor a bond fund that holds bonds of a fairly short maturity, perhaps not more than 3 years. Without boring you with algebra, the longer the term of the bond, the more the price of the bond will fluctuate, thus increasing the risk that your investment will not be worth what you want when you want it.What we are doing is matching our tolerance for risk to a type of investment asset that is well-suited for that level of risk.I am ahead of you...I know what you are thinking: “This sounds pretty good. Couldn’t I just move my emergency fund from a savings account to a bond fund then?” No, and I will tell you why. Because while the value of a short term bond fund will not usually vary by much, it will indeed be variable. At any given point in time, and Murphy’s Law being what it is, it could very well be at a dip just at the moment when you need to access these funds. When you compare the possible rate of return of a bond fund (or any investment) to the locked-in rate of return of a savings account or CD, you are in essence comparing uncertain apples to guaranteed oranges.Balancing a financial goal with the right investment is part science(investment principles) and part art(your risk-taking preferences). And while the Your Money Line team does not provide specific investment advice, we are very happy to help you puzzle through the decision.