The key isn't to take no risk at all, but to let the probabilities tell you how much.
By Christine Benz | 08-12-16 | 06:00 AM | Email Article

Just as putting and chipping look deceptively simple to beginning golfers, so can the process of investing for shorter time horizons trip up investors. It looks so easy, but it can be difficult to get right.

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.

Investors may confuse their risk capacity with risk tolerance, for example, venturing out on the risk spectrum and incurring losses just before they need to tap their portfolios. Or they might assume that just because stocks have delivered returns that have bested other asset classes' in the past five years, they'll do it again during the next five. 

At the opposite, conservative extreme, investors might assume that the best way to meet short- and intermediate-term goals is to stick exclusively with guaranteed products such as CDs or money market accounts. That's not an unreasonable idea given how small the current differential is between cash and products that do not promise stability of principal; for very near-term expenditures, cash is best. But if the investor's time horizon is longer than a couple of years, the bite of inflation means that guaranteed products will be a losing proposition. 

Running the Numbers
Investing for short- and intermediate-term goals is, in many ways, a game of probabilities. While the S&P 500 posted a positive return in 92% of rolling 10-year periods in the past 25 years, stocks have been much less of a sure thing for shorter time horizons. Over rolling one- and three-year periods from August 1991 through July 2016, the S&P has posted a loss roughly 22% of the time, and some of those short-term losses were punishing, especially in one-year windows. The unlucky soul who invested in the S&P 500 in early 2008 and needed to get his money out a year later would have had to settle for a 43% loss, for example. 

Meanwhile, bonds have a much higher probability of holding their ground over shorter time periods. During the same 25-year period, which was admittedly strong for bonds, the Barclays U.S. Aggregate Bond Index had a positive return in every rolling three-year time period and in 92% of rolling 12-month periods. And the worst 12-month loss for bonds was much milder than what stocks incurred at their nadir: just 3.7% (between late 1993 and late 1994). Of course, past is not prologue. In a sustained period of rising interest rates, bond losses could be higher and more frequent than they have been in the recent past.

What's a well-meaning short- or intermediate-term investor to do?

Well, even if bond returns aren't a sure thing to make money going forward, that doesn't automatically make stocks the better bet for short- or even intermediate-term time horizons. Historical returns suggest that if your time horizon is less than 10 years, stocks' returns have been too unreliable for them to be a worthy receptacle for the whole of your money. Stocks might be a component of a portfolio if the time horizon is close to 10 years, but they shouldn't be the whole kitty. Investors have even more reason to check their near-term expectations for stocks as they've been on an extended tear for most of the past seven years and that valuations, while not at skyscraper levels, aren't especially low right now.

The answer is that if you're saving for a goal that's close at hand, whether a home down payment, remodeling, or a special family trip in five years, you need to take some risk but not too much. You also need to recognize the role your savings rate plays in all of this: If returns from reasonably safe asset classes are apt to be muted during your holding period--and current bond yields suggest they will be--you may need to step up your savings rate to achieve your goal rather than relying on portfolio returns to do the heavy lifting.

The following portfolios are geared toward investors who expect to need their money over the short-term (within five years) or intermediate term (within 5-10 years). Investors with very short time horizons of just a few years should stick with cash. Because many investors save for short- and intermediate-term goals outside of their retirement accounts, I've created portfolios for both taxable and tax-deferred accounts.

A Short-Term Portfolio for Taxable Accounts
Spending Horizon: 5 Years or Less

This portfolio is geared toward taxable investors with time horizons of roughly five years. Thus, it's anchored in cash (certificates of deposit, money market accounts, and so forth) and a short-term bond fund. It also features an intermediate-term fund to help boost its yield, albeit with a bit more volatility.

Morningstar analysts have long been impressed by Fidelity's careful and deliberate approach to the muni markets, and the funds that dominate this portfolio showcase what the firm does well. Both the Limited Term and Intermediate funds are managed by Fidelity veteran Mark Sommer, who eschews risky credits and leveraged structures. That means his charges typically hold up well in muni market shakeups such as 2008 and 2013. That attention to downside protection makes these funds a good fit for short-term investors.

Short-Term Portfolio for Tax-Deferred Accounts
Spending Horizon: 5 Years or Less

  • 20%-40% Cash 
  • 40%-60%  Fidelity Short-Term Bond  
  • 20%:  Dodge & Cox Income

This portfolio is geared toward investors with time horizons of roughly five years; it mirrors the structure of the taxable portfolio above but doesn't pay attention to tax efficiency. Cash instruments--CDs, money market funds, and money market accounts--make up as much as 40% of the portfolio, with a high-quality short-term bond fund composing another 40%. I've used Fidelity Short-Term Bond, though other high-quality short-term medalist funds would work well here, too.

A smaller portion of the portfolio goes into an intermediate-term bond fund to boost the portfolio's yield, though with a bit more volatility than what accompanies the short-term fund. Here, I've used Dodge & Cox Income, whose managers' three- to five-year time horizon for their holdings syncs up with the five-year time horizon of the portfolio. But investors could reasonably use other medalists within the intermediate-term bond category, such as a total bond market index fund,  Fidelity Total Bond , or  Metropolitan West Total Return Bond , to name a few.

An Intermediate-Term Portfolio for Taxable Accounts
Spending Horizon: 5-10 Years 

  • 20% Cash 
  • 20% Fidelity Limited Term Municipal Income 
  • 40% Fidelity Intermediate Municipal Income 
  • 20%  Vanguard Total Stock Market Index  

Geared toward a taxable investor with a spending time horizon between five and 10 years, this portfolio includes cash and the same municipal-bond funds that appear in the portfolio above, albeit in slightly different allocations. It also includes a slice of tax-efficient equity exposure. I've used a broad market traditional index fund, but investors could reasonably use a large-cap exchange-traded fund or a tax-managed equity fund such as  Vanguard Tax-Managed Capital Appreciation .

An Intermediate-Term Portfolio for Tax-Deferred Accounts
Spending Horizon: 5-10 Years 

  • 20% Cash 
  • 20% Fidelity Short-Term Bond 
  • 40% Dodge & Cox Income 
  • 20%  Vanguard Dividend Appreciation  

This portfolio, geared toward investors in lower tax brackets or those investing in tax-deferred accounts, is stair-stepped by risk level, from cash to short-term bonds to intermediate-term bonds to stocks. I've mirrored the allocations of the taxable intermediate-term portfolio above but have not factored tax efficiency into the investment selections. Vanguard Dividend Appreciation is one of Morningstar's favorite core equity funds, and it has historically had a lower downside capture ratio than other core equity funds. Investors could reasonably use a low-volatility equity fund or a total market index tracker in its place.

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Christine Benz has a position in the following securities mentioned above: VWITX Find out about Morningstar's editorial policies.
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