Where Should You Invest Money You'll Need in 5 Years or Less?

When you invest your money, you want to earn the highest return possible. But, investing is an inherently risky activity.

If you absolutely need money within 5 years, prudence dictates that you should dial down the risk a bit with your investments.

But, how can you invest and still earn a return, even if you need the principal back within 5 years?

With that short of a time frame, your investment options are limited. But, there are still some good choices that can earn you more than just keeping your money in cash.

Here’s a look at some popular investment options, along with an analysis of where they lie on the risk-reward spectrum.

Popular Investment Options

All of these investment options of the potential to make money. However, some are better suited for long-term investing than short-term investing.

1. Stocks

For many investors, stocks are the first choice they think of when it comes to making an investment. After all, over the long run, stocks have provided a much better return than bonds, cash, gold or other popular investments.

The problem with stocks for those who have a short time frame is their volatility.

True, the long-term returns for stocks are impressive. But, the short-term selloffs can be vicious.

In the 2008-2009 financial meltdown, for example, the stock market fell by more than 50 percent.

If you were saving for a short-term goal, that kind of loss could be devastating.

Stocks may be a great investment for the long-term, but if your investment horizon is 5 years or less, you’d probably be better served looking elsewhere.

The risk of capital loss over the short-term is just too great. Even a diversified portfolio of index funds and ETFs can prove to be risky if the underlying securities are held mostly in stocks.

2. CDs

Certificates of deposit are a good option for short-term savings.

CDs offer higher rates of interest than most checking or savings accounts. You can usually select from a broad range of maturity dates, from as little as one month to as long as 20 years in some cases.

CDs also carry FDIC insurance, up to $250,000 per account.

Investment minimums usually start at $1,000. Many CD accounts, such as those offered by online banks, have no minimum investment.

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3. Series I Savings Bonds

Series I savings bonds are another low-risk savings investment offered by the U.S. government.

The main benefit of Series I bonds is that they carry no inflation risk.

The interest you earn on a Series I bond is a combination of a fixed rate and a semi-annual inflation rate. When inflation goes up, so too does the interest you earn on the bond.

You can buy Series I bonds electronically for as little as $25. Bonds are issued in terms ranging from 1 year to 30 years.

The one drawback for shorter-term investors is that you must forfeit the previous 3 months of interest if you redeem the bond before 5 years.

If you have a 5-year window for investment, however, a Series I bond is both secure and inflation-resistant.

4. Online Savings Account

Online savings accounts are viable options for short-term money.

Savings accounts, in general, don’t pay a lot. In fact, according to the Federal Reserve Board, the average savings account rate is just a few hundredths of one percent.

Online savings accounts, however, often pay much higher yields. You can expect to earn at least 20 times the “average” savings account rate by going with an online bank.

Reduced overhead is the main reason why these banks can pay higher levels of interest.

Best of all, savings accounts are readily accessible. A simple click on a website, or a phone call to your broker, and you can have your money transferred out to you immediately.

You’ll likely need as little as $1 to open an online savings account.

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5. Corporate Bonds

Corporate bonds are a more advanced investment option for most people. They make regular interest payments and return principal to investors at maturity.

Corporate bonds come in a range of maturity dates, so you could consider investing in one that comes due in 5 years or less.

The main risk with corporate bonds is that the company becomes financially insolvent and can’t afford to pay interest or principal.

You can minimize this risk by purchasing highly-rated bonds.

Most corporate bonds are rated by third-party, professional rating agencies, like Standard & Poor’s. These ratings reflect the likelihood of default.

The top of the rating scale is AAA, with ratings of AA, A and BBB still considered “investment grade.”

Most corporate bonds have a face value of $1,000. You must purchase bonds in whole units, so you’ll need about $1,000 to buy individual corporate bonds.

6. Treasury Bills

As another more advanced option, Treasury bills are among the safest investments available. Your interest and principal is backed by the “full faith and credit” of the U.S. government.

Treasury bills come in maturities of 4, 13, 26 and 52 weeks. So-called “cash management bills,” which are another form of Treasury bills, are issued in terms of just a few days.

Bills are sold at a discount and grow in value until they mature at $1,000 each. Thus, you can expect to pay slightly less than $1,000 to buy a single Treasury bill.

You can also invest directly through Treasury.gov in increments of just $100.

The interest rate on Treasury bills is determined by auction.

Treasury bill rates are typically fairly low, due to their safety level. However, rates are usually higher than the average checking or savings account.

When Does It Make Sense to Invest?

Investing is a long-term game. Money you set aside for long-term investments shouldn’t be raided for short-term needs.

That’s why most financial experts advise that you set up an emergency fund before you begin investing.

After establishing an emergency fund

An emergency fund should contain somewhere between 3 and 6 months of your essential expenses. This fund can protect you from having to go into debt in the event of an unexpected car repair, for example.

Ideal Size of an Emergency Fund

Your emergency fund can also cushion you if you were to suddenly lose your job.

The last thing you want to do is to go into debt or raid your investment account if you have a short-term need, so an emergency fund is an important first step.

After paying off debt

Debt is a killer. Debt saps your financial resources. With interest charges, your debt can increase rapidly.

The reason is that interest charges on credit cards often reach the high double digits.

That’s a greater expense than you can generally earn through investments.

This makes paying off debt before you invest a smart move.

After living comfortably within your means

If you’re struggling to live paycheck to paycheck, you might want to put your investment goals on the back burner.

Not that investing isn’t important. But, if you can’t eat or pay all of your bills, trying to set aside additional money that you don’t have for investing can be stressful.

Plus, your chances of success are less likely. The first time that you can’t pay your bills, you’ll have to tap into your investments, possibly at an inopportune time.

Once you’ve got a buffer of comfortable income, automate your investment savings.

Take this money out of your account first. If you leave your investment savings until last, it might not be there.

Human nature being what it is, you might find that money going to discretionary expenses rather than savings.

What You Are Trying to Avoid

Most investors only think of what they can make when they put away money. An important thing to consider is what you are trying to avoid.

Principal loss

No matter how short your time frame, you want your investments to do well. But, with a short time frame, you won’t be able to recover from principal losses.

If you’re saving for retirement in 30 years, you can afford to be more aggressive with your investments, because you have more time to ride out short-term losses.

If your time horizon is short, limiting the risk of principal loss is more important than striving for the best return possible.

Inflation

Inflation refers to prices going up for goods and services.

Inflation is a killer when it comes to investments. If your investments can’t keep up with the rise in inflation, you’re essentially losing money.

This is why people invest instead of keeping their money in cash, which pays nothing.

However, bonds carry inflation risk as well.

Imagine this scenario: You invest in a portfolio of long-term bonds. They seem like a good, safe investment, since you will receive your money back when they mature in 20 years.

Here’s the problem. If you put $10,000 into these 20-year bonds, your $10,000 won’t pay for the same amount of goods and services as it did when you first invested.

In fact, at the long-term average U.S. inflation rate of 3.22 percent per year, prices will double roughly every 22 years.

This means that the $10,000 you get from your bond in 20 years will buy just over half of what it does now.

The good news for the short-term investor is that inflation isn’t quite as devastating over the short run as it is over the long run.

Considering the safety they impart, savings bonds and savings accounts can be better choices than stocks if you’re a short-term investor, even with the small amount of inflation risk you’ll encounter.

Inaccessibility

Another problem with some investments is that they are illiquid.

An illiquid investment is one that it is hard to get your money out of when you need it.

Stocks, bonds, and cash are all liquid.

• Stocks are more liquid than bonds because they trade on a stock exchange.
• Bonds are less liquid, but you can easily find a buyer for most bonds.
• Cash is cash, the most liquid of all asset classes.

What you want to avoid as a short-term investor are investments like annuities. Annuities are insurance-based investments that you can’t access before age 59 ½ without paying a penalty.

You should also avoid retirement accounts, such as IRAs and 401(k)s, for short-term investments.

Like annuities, they carry penalties for withdrawals before age 59 ½. In the case of a 401(k), you might not have access to that money unless you leave your job or can demonstrate a financial hardship.

Obviously, these aren’t good options for short-term money. No matter how your money may perform in these accounts, if you can’t get it out when you need it, it doesn’t help you.

Conclusion

When investing, you should try to get the best return you can. However, you should balance your quest for gains with your need for capital preservation.

This is particularly true if you have a short-term investment horizon of 5 years or less.

Many investments with potentially higher returns, like stocks, are not suitable for short-term investments. The risk of capital loss is just too great over short time horizons.

Another risk to watch out for is inflation. Bonds may be more secure than stocks, but the money you get back at maturity won’t be worth as much as it is now.

Series I bonds lie in the sweet spot, as they generate income and you’re protected against inflation. But, you’ll face an early redemption fee if your time horizon is less than 5 years.

Liquid investments such as online savings accounts may be a good option, as they can pay a decent yield and still be fully liquid.

Whichever way you choose to go, just remember that all investments carry at least some level of risk.

The first step is to educate yourself as to the risk and reward of each type of investment.

Then, you can decide which risks you are prepared to accept and invest accordingly.