By JLP | November 11, 2010
This is a guest post by Doug Warshauer, author of If I’m So Smart Where Did All My Money Go: Balancing Your Financial Objectives for Lasting Wealth (Personal Finance)*. I met Doug through Twitter. Gotta love social networking.
My friend Tom plans to buy a car in two years. His current car, a 2003 Chrysler, is nearing the end of the line. Tom recently began setting aside some money each month, hoping that, two years from now, he’ll have enough accumulated to purchase his new vehicle. The car he has his eye on: a Honda Accord, which he estimates will cost him about $27,000.
Tom, and millions of other people in similar situations, face a dilemma right now: how to invest that money which they plan to spend in a couple of years. He realizes that two years is far too short a window of time to invest in stocks. When the stock market falls – as it has numerous times in the past decade – the losses could wipe out a substantial portion of his savings and delay his ability to buy the car.
Unfortunately, with short-term interest rates near zero, Tom finds all the investment options unappealing. Bank savings accounts, 2-year CDs, Treasury bills, and money market funds all offer negligible returns. With such undesirable options, he feels tempted to find some alternative investment vehicle.
What should Tom do? Here is my suggestion:
First, he needs a little perspective. While nominal short-term interest rates are at an all time low, real interest rates (inflation-adjusted) are not too different from historical norms. Tom is not going to get much of a return on his investment, but the cost of the car is also not likely to rise much, either.
His ability to buy the car in two years depends on two factors: 1) saving enough money each month, and 2) not losing the money he saves through poor investing.
How can he keep from losing it through poor investing? The biggest risk we’ve already mentioned: he must avoid the temptation to invest in the stock market. Still, even if Tom sticks to fixed income investments, he needs to avoid the temptation to accept two other risks that could undermine his ability to buy that car.
First, he needs to protect against credit risk, the risk that the security he buys will fall in value if the likelihood that its underlying investments default. Tom can essentially eliminate credit risk by purchasing U.S. Treasuries, putting his money in a bank that offers an FDIC guarantee, or investing in a bond fund that buys highly rated securities. While mutual funds that buy high-yielding (lower rated) bonds might offer tempting interest rates, they could fall sharply in a down market, when the risk of default of lower-rated bonds skyrockets.
Second, he needs to protect against interest rate risk, the risk that the security he buys will fall in value if interest rates rise. He can eliminate most interest rate risk by purchasing securities with a short duration. Savings accounts, money market funds, and short-term bond funds all fit this description.
As with credit risk, Tom may be tempted to accept some interest rate risk in order to earn a higher yield. Currently, a 2-year Treasury yields about 0.5%, and a 30-year Treasury bond yields about 4.25%. After all, with a highly liquid market for Treasuries, he’ll be able to sell the 30-year bond when he wishes to buy the car.
If he buys the 30-year bond, and interest rates rise, he could be in for a shock in two years. An increase in long term interest rates of two or three percent could wipe out 25% or more of the value of his investment! Once again, the downside of chasing a higher return dwarfs the modest benefit.
True, to avoid credit risk and interest rate risk, Tom must resign himself to accepting the negligible returns he will earn investing in high-quality, short-term fixed income investments. But accepting them comes with a real reward: the near certainty that two years from now, as long as he saves as much as he intends, he will be the owner of a new Accord.
What would you do? Would you be tempted to seek a higher-yielding investment?
Doug Warshauer’s new book, If I’m So Smart Where Did All My Money Go: Balancing Your Financial Objectives for Lasting Wealth (Personal Finance)*, teaches how people can design savings and investment plans to meet all their financial objectives. He blogs on personal finance issues at www.dougwarshauer.com.