FIGURE OUT HOW much money you’ll need from your portfolio over the next five years. We’re talking here about the funds needed to pay your teenager’s college bills or to cover the next five years of your retirement expenses. With such a short time horizon, you simply can’t afford to take a whole lot of investment risk. You should also play it safe with your emergency money, even though you can’t be sure when you’ll need it.
For the money you will spend over the next 18 to 24 months, go for cash investments, like a low-cost money-market mutual fund or a high-yield savings account. Meanwhile, for money you’ll need from your portfolio over the subsequent three to five years, look for a high-quality short-term bond fund. For extra safety, favor a short-term bond fund that invests partly or entirely in government bonds. These bonds are less likely to slip in price during an economic slowdown—something that could happen even with high-quality corporate bonds.
Why not stick the entire five years of spending money in a cash account? A short-term bond fund will give you modestly more yield. Even then, you’re unlikely to make much, if any, financial progress, especially once inflation and taxes are figured in.
While investors spend many anxious hours trying to figure out which long-term investments to buy, they often pay scant attention to the yield they earn on more conservative investments. Financial institutions are well aware of this, so they often charge high fees on cash accounts—either explicitly or implicitly—leaving them with handsome profits and their investors with tiny yields. Is your financial firm gouging you? To check, compare the yield on its cash account to that available on Vanguard Prime Money Market Fund, which is consistently among the top-yielding money-market mutual funds.
What if you like a financial firm’s other offerings, but not its cash account? You might minimize the amount of cash you hold at your main brokerage firm or fund company, and instead keep the rest in, say, a high-yield savings account.
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