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Short-term investments and strategies: What to know

At a glance:

Perhaps you're comfortable choosing investments for goals that are 15 or 20 years away—say, for your retirement or for your toddler's education.

After all, 20 years is a long time, and you can handle the volatility that comes with investing if you know you don't need the money any time soon.

But you're probably less comfortable choosing investments for goals that are within spitting distance. Like buying that bigger home in three years. Or sending your teen to college in two years. Or taking a European jaunt in four years.

Here are some options for how to invest for short-term goals, along with the pros and cons of each.

(Getty)
(Getty)

Money market funds and certificates of deposit

Money market funds

Many people park money they'll need soon in a money market account. And for good reason: Money market funds are pretty secure.

But investors may do better by taking on a bit more risk. The average ultrashort-bond fund returns a little more annually versus the average taxable money market fund.

That may not seem like a lot, but compounded over a few years, it could mean the difference between flying first class to Europe and being confined to coach.

Certificates of deposit

Certificates of deposit (CDs) are often popular with investors because, like bank accounts, they're insured. Bonds and bank-loan funds generally are not.

Don't get too bogged down in the insurance issue, though. The types of boring bonds used in short-term investing rarely go belly up.

For that to happen, the U.S. government and a host of blue chip corporations would have to become insolvent. And if that happens, short-term investments may be the least of your worries.

The biggest benefit, however, is that a CD's return is predictable. It's guaranteed. Bond funds aren't that predictable. (A bond fund is less predictable because its return is composed of both income and changes in the prices of the bonds it owns.)

Timing is the biggest problem with CDs. A CD requires that you hold it for a set period. If you cash in sooner, be prepared for substantial early-withdrawal penalties.

The penalties typically range from three to six months' worth of interest. But CDs can be great choices for investors who know exactly when they'll need their money.

Ultrashort bond funds and short-term municipal bond funds

Ultrashort bond funds

Ultrashort-bond funds invest mainly in Treasury, mortgage-backed, and corporate bonds. They limit risk by sticking with short-term securities.

With an average duration of just six months, they don't feel much pain when interest rates rise. Money markets, by contrast, carry durations near zero, but offer lower returns.

If you don't want to put your principal at risk, but would like to eke out a little more return, ultrashort funds are a good first step away from money market funds.

Some funds dip into lower-quality bonds for their higher yields, though. Such funds look safer than they are, because bond defaults have been few and far between in recent years.

Short-term municipal bond funds

Short-term municipal bond funds, or munis, buy slightly longer-term securities than ultrashort bond funds do.

Because they carry longer durations, short-term muni funds are more sensitive to interest rate shifts than ultrashort funds. Therefore, they gain more than ultrashort funds when interest rates drop.

Buying an insured muni fund won't lessen the interest rate risk. While insurance protects against defaults, it can make funds even more vulnerable to rate changes.

If you're saving for a home or another longer-term goal and you can weather some rougher patches, short-term muni funds fill the bill—especially if you're in a high federal-tax bracket.

That's because these funds only buy municipal bonds, whose interest is exempt from federal income taxes.

Bank loan funds

Because they invest in floating-rate bank loans taken on by corporations, bank loan funds have very little interest rate risk. They yield more than many other options, with the potential to go higher if rates rise.

Where the risk lies

The big thing to worry about is borrowers defaulting. When the economy is humming along, that's not much of a problem.

And even when the economy does slow, banks are among the first creditors in line when a business goes belly up.

Companies that have defaulted so far have made good on their floating-rate loans more than 80% of the time; distressed junk bonds haven't done half as well.

What to look for in a bank-loan fund

When shopping for a bank loan fund, beware of high costs. Many funds charge back-end loads if you don't stay in for a minimum time (typically, at least a year).

Further, their expense ratios are often higher than the average bond fund's.

Bank loan funds work best for investors who will need to draw on the money at a predictable time.

Because most bank loan funds allow investors to redeem their shares only once each quarter, they aren't good places to keep money you might need in an emergency.

So if you sock money away for that trip to Europe in a bank loan fund, be sure to withdraw far enough in advance.

Summary of short-term investments and strategies

Short-term goals generally call for bonds and money market investments because the alternative—equity investments—have more danger of loss.

And that's the last thing you need when saving for a goal you want to fulfill within a few years.

Some investors do use equities such as stocks and mutual funds for short-term goals, but that is usually the exception. For safety's sake, most investors stick with bonds.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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