A “simple” way to invest for a short term goal
Just because something is simple, does not make it simplistic, which almost always is used to connote something negatively. And just because you like to keep things simple, does not make you a simpleton. I am amazed at how some people want to overdo the simplest of things, as if by employing the complex strategy the outcome will be better than if a relatively simple strategy was utilized.
It’s kind of like writers using “five-dollar” words, when using “one-dollar” words are sufficient to get the point across. Perhaps it’s an ego thing: the writer feels superior when their audience is forced to use a thesaurus (!) or google an unknown word.
Recently I was asked by one of my friends to help him deploy a financial strategy for a short term goal (which I’ll generally define as one that is less than 5 years away). In this case, the “goal” date for using the money was 4 years away. If you remember this previous post, I commented that it’s absolutely necessary to consider the time-frame for when the funds will be needed.
Failing to do this very basic concept can lead to poor (or disastrous) results.
Monies allocated to equities for short term goals are generally considered *unsuitable* as you may need to liquidate at the “wrong” time, say in a declining market. The inverse is also true, if money is allocated too conservatively for a longer term goal, you run the risk of not having “enough” money after the effects of inflation are considered. It’s these type of issues that the so-called “financial professional” world uses to prey on an financially uneducated populace.
The (unstated but essential) message: You *need* them to figure this stuff out for you because you can’t do it on your own.
It’s not true, of course: anyone with a high school senior math education can follow the basic concepts “along at home”. And despite the pleadings of the financial planning community to the contrary, financial planning is *not* an exact science. Heck, I’m not even sure it’s an “art”; more of a *discipline* than either an art or science.
…zzzzZZZZZzz…
… oh no, there I go again… Sorry about that. Let’s get back to the issue at hand: How did we decide to deploy capital for a 4 year time horizon? Bonds. Absolutely *not* sexy, but they get the job done and are appropriate and suitable for the task at hand.
First, we have to make sure that the investment is low-cost as every dollar confiscated in fees by the investment “professionals” reduces the investment’s total return. (Stunningly simple concept, isn’t it?)
Second, we have to make sure that the investment is internally diversified, meaning we want to hold many bonds to reduce the default risk of any one bond issuer defaulting on its obligation to repay.
Third, the bonds have to be of the highest quality, reflecting the bond issuer’s ability to repay. We need to preserve and protect capital, so “junk” (also known as “high-yield”) bonds were not suitable.
Fourth, we’d like to match the average duration (which is essentially, a measurement of how long, in years, it takes for the price of a bond to be repaid by its internal cash flows) to the goal time-frame: in this case, 4 years.
So, following the 4 steps above leads us to the obvious answer: we were looking for a low-cost, mutual fund of high quality bonds with an average duration of 4 years.
Checking out Vanguard Group, my favorite mutual fund family for DIY investors, two bond mutual funds were reviewed: Vanguard’s Short Term Bond Index and their Intermediate Term Bond Index. As of today, the Short Term Bond Index holds 900 bonds and has an average duration of 2.5 years. Intermediate Bond Index holds 968 bonds and has an average duration of 6 years. Both funds have an overwhelming majority of their holdings in bonds that are rated “A” or better and both have an expense ratio of 0.18%, making them *very* low cost.
So, let’s recap:
- Low-cost? Check.
- Diversified? Check.
- High quality holdings? Check.
- Duration of 4 years? Uh-oh.
Darn. Everything was going so well until we got to #4.
Fret not, here’s the easy solution: We can “blend” the two funds together to get to our desired average duration of 4 years. The math worked out like this:
- Short Term Bond Fund duration is 2.5 years * 60% (0.6) of the total invested = 1.5 years; and
- Intermediate Term Bond Fund duration is 6 years * 40% (0.4) of the total invested = 2.4 years.
By investing 60% of the money in the Short Term Bond Fund and the remaining 40% in the Intermediate Term Bond Fund, we essentially have created a portfolio that has an average duration of 4 years. (Actually 3.9 years, if you want to get “technical” on me!).
One more thing: please be aware that bond fund durations are subject to change over time. You may need to adjust the “blend” as circumstances dictate.
But using this “simple” solution to invest for a short term goal, you’ll achieve better results than many of your friends. Of course, there is the possibility I could be wrong 