Generally speaking, investing is a long-term process. You invest in your IRA and 401(k) to reach a long-term goal – retirement. You may invest in a 529 education savings plan for many years to reach another long-term goal – college for your children. But is there also a place in your portfolio for shorter-term investments?
In a word, yes. You have three good reasons for owning short-term investments: liquidity, diversification and protection of longer-term investments. Let’s look at all three:
Liquidity – For many people, the COVID-19 pandemic brought home the need to have ready access to cash, and short-term investment vehicles are typically liquid. Still, some are more liquid than others, and you’ll want to know the differences right from the start.
Probably the most liquid vehicle you could have isn’t an investment at all, but rather a simple savings or checking account. But you likely could earn much more interest from a high-yield online savings account without sacrificing much, if any, liquidity. Money market accounts are also highly liquid, but they may carry minimum balance requirements.
Other short-term investments may be less liquid, but that may not be a major concern if you don’t need the money immediately. For example, you could purchase a type of mutual fund known as an ultra short-term bond fund that invests in longer-term bonds due to mature in less than a year, so you could receive the benefit of the higher interest rates typically provided by these bonds. You could choose to partially or entirely liquidate your bond fund at any time, but it may take several days for the sale to go through, since the shares in the fund need to be sold. You could also invest in a three-month certificate of deposit (CD), but if you cash it out early, you’ll lose some of the interest payments.
Diversification – If your portfolio consists largely of stocks and stock-based ETFs and mutual funds, you could take a hit, at least temporarily, during periods of market downturns, which are a normal part of the investment world. But a diversified portfolio, containing both long- and short-term investments, may hold up better during periods of market volatility. That’s because the short-term vehicles we’ve looked at are typically going to be far less affected by market movements, if they’re affected at all. (Keep in mind, though, that diversification by itself can’t guarantee profits or protect against all losses.)
Protection of longer-term investments – If you were to face an unexpected expense, such as the need for a major home or car repair, how would you pay for it? Without any liquid reserves, you might be forced to dip into your long-term investments, such as your 401(k) and IRA. But by doing so, you could incur taxes and penalties – and, perhaps even more important, you’d be removing resources from accounts designed to help you achieve a comfortable retirement. With enough short-term investments in place, though, you can avoid touching these long-term accounts.
As you can see, you can benefit significantly by adding some short-term investment vehicles to your portfolio. They could make a big difference in your ability to meet your financial goals.