Mail Bag: What to Do With Intermediate-Term Savings

We have our first mailbag question, and it’s a great one!  I’ve removed the name, but here’s the email I received.  Remember, if you have a planning question that you’d like to see answered here, email me!

Dear Tony,

We are about to have a large transition in our life involving a relocation.  We will have a substantial chunk of money from the sale of our house, and possibly more from the sale of our business.  We haven’t decided what our living situation will look like at first.  I don’t want to park that money somewhere where we’ll get dinged for trying to use it later, but I don’t want it sitting in a bank account earning nothing.  Where is a good place to park some of that money for a 3-5 year window?

Thanks for the help!

This is a question that comes up far more often today than it did in the pre-2008 interest rate environment.  It’s not hard to imagine why.  A quick search revealed this article from consumerismcommentary.com detailing a day in 2007 when ING Direct (an online bank that has since become CapitalOne360) dropped their savings account rate from 4.5% to 4.3%.  The author even makes mention of his other savings accounts earning 5%.  Today, those same types of accounts are earning around 1.0%.1

Before we dig into the options, I want to make a quick point.  Like most financial planning questions, even this relatively simple question has several possible answers.  Most people (many advisors included) will jump straight to the “mathematically correct” answer.  Statistically, the ‘<such and such>’ will perform ‘<thus>,’ while the ‘<other thing>’ has never had a down period of more than ‘<time frame>’ in ‘<longer time frame>’.  It’s dizzying, really. It’s important to assess all of the pros and cons of your options, and I’ll try to lay out the situational concepts right alongside the technical.

So, let’s look at some of the options this saver has, in what I would imagine most people believe to the order of their “riskiness”:

  1. At Home/In the Safe/Under the Mattress
  2. Bank Savings Account
  3. Bank Certificate of Deposit (CD)
  4. Bond Mutual Fund
  5. Stock Mutual Fund

If you’re already familiar with these options, you may want to jump down to the bottom of the post where I bring it all back together.

At Home
Some people think of this as the safest place they can keep their money.  In some sense, that may be true, but there are risks here to be considered, as well.  Currency at home is exposed to risk of theft or fire.  It’s (arguably2) easier to spend, and so at risk of not being there when you need it.  Over any long-ish period of time, the real risk is that the money at home doesn’t grow at all.  Meanwhile, the price for whatever you might buy with it is almost constantly increasing (inflation).  If I bury $1,000 behind the woodshed so I can buy a <whatever>, but I don’t go get it for 3 years and the price has climbed from $1,000 to $1,100, then I hurt myself.

I typically advocate clients having some “cash-on-hand” at home, but it’s more about empowering them to exploit opportunities than a safe savings vehicle.  The amount is different for everyone, and depends on what an “opportunity” might look like for them.  I have one client who rebuilds custom cars.  He’s saved thousands of dollars on buying because he keeps enough cash at home to make quick offers.

Bank Savings Account
The old standby.  You bring your money to an institution, they pay you some interest rate.  There are mechanics behind how that works, but this post is already going to be wordy enough. 🙂  Remember, interest/investment returns are compensation for the risk you are taking when you give the money to the institution.  There’s not a lot of risk in letting a bank hold your money for you, so you get… not a lot of interest.

There are various flavors of this to look into; some old, some new.  You’ll often get a slightly higher rate at a local credit union than you would at one of the mega- or super-regional banks.  You can also find a higher rate at online banks that don’t have the overhead of their brick-and-mortar cousins, which means they can cover more competitive rates.

Regardless of your choice of bank, with a savings account there’s no real limit to accessing your money, you shouldn’t be charged any fees, and the money is typically insured against loss due to institutional failure.

CDs
Banks subsidize the interest rates they pay in your savings account by loaning out a portion of the money they hold.  (I know, I promised I wouldn’t go into it…) When a bank has a good idea of how long they’re going to hold your money, they can better plan around it.3  Enter the certificate of deposit.  You promise to leave your money with the bank for a set period of time, typically a choice of 3 or 6 months,1 year, 3 years, 5 years or 10.  In exchange for that certainty, the bank pays you a higher interest rate.  The caveat is that, should you break your contract early, you lose some or all of the interest income as a penalty.

For clients who don’t know exactly when they may need some or all of the money, it may be advantageous to “ladder” CDs.  This approach purchases CDs of different terms, and then as each comes due, rolls the funds into a new CD with the longest acceptable term.  This results in always having some liquidity coming due at various points, but also being able to benefit from the higher interest rates tied to the longer-term CDs.

Bond Mutual Funds
A bond is nothing more than a loan to an institution.  A bond mutual fund is a large basket of bonds which investors can buy a piece of in the form of shares.  The upside of this is that you get to spread your risk across lots of companies.  The downside is that mutual fund shares are bought and sold, which affects their price.  As I write this in the 4th quarter of 2015, we find ourselves in one of the lowest interest rate environments in history.  At some point, interest rates will begin to rise again, and when interest rates rise, bond prices fall.  Since the bond mutual fund share price is also a function of the price of the underlying bonds, their share price will be negatively impacted as well.

I know the above paragraph sounds negative, and those are risks.  Remember, though, return is compensation for risk.  The bond fund can be an incremental step up in each.

Stock Mutual Funds
Most of the time, stocks are “out of bounds” for conversations about short- and intermediate-term savings.  Stocks, and therefore stock  mutual funds, are unpredictable.  Unpredictability is often the last thing a client wants when they have a specific approaching goal. That being said, the potential gain of a small stock allocation may outweigh the potential for loss, especially if you have any flexibility around when you need the funds.

As an example, imagine that you have $100,000 of your intermediate-term savings in cash earning 1%.  If you shifted 10,000 into a stock investment that return 10% over the next year (large cap stocks averaged 10.9% 1995-2014)4, you would almost double your expected return to 1.9%.  If those rates were static, at the end of 5 years, you’d end up with $5,600 more than you would have had in a cash-only position.

Let’s talk about the downside.  Assume the above, but you invested at the worst possible moment, and the stock portion of your savings proceeds to decline by 50% in rapid order.  If it happened “immediately,” you now have $95,000.  There are two planning questions to ask. First, can you buy what you originally needed for $95,000?  Second, can you postpone your purchase until market recovery?

Bringing It Together
The short answer to the mailbag question is probably some blend of the above choices.  The actual proportions of that blend are going to depend on how flexible the asker is in terms of timing, how concrete their savings goal is and their appetite for risk.  From the sound of the question, if you’re relocating but looking at a 3-5 year window for the savings from your home sale, it sounds like you have some flexibility and could be at the more aggressive end of this (some number of months’ emergency fund in cash/bank savings, and the larger chunk in a 10% stocks/90% bonds portfolio).  If things are good, you buy more or buy sooner.  If things are not as good, you buy less or postpone your purchase.

That’s a much different proposal from someone who is facing a college tuition bill in 3-5 years.  Known amount, known timeline.  That would be a situation that requires more certainty, and a more conservative portfolio.

——

1Source: MagnifyMoney.com

2There’s scientific evidence that physical cash is emotionally more difficult for us to spend than, say, the money we have in the bank and can be accessed via debit/credit card.  Check out the work of Elizabeth Dunn and Michael Norton.

3There are some huge oversimplifications in this article, so don’t nitpick. 🙂

4Source: Blackrock

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Mail Bag: What to Do With Intermediate-Term Savings

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