- Traditional advice is to never invest short-term savings.
- But investing a small portion of these savings may provide households with a tangible benefit.
- Over an investment lifetime, adhering to the status quo can lead to a significant drag on an investor’s overall long-term wealth.
Conventional wisdom is to never invest short-term savings. Granted, this is considered to be the safest approach. But there may be another option out there that’s worth considering. Let’s explore.
What Others Say
If you are saving for a big purchase, you’ll want quick access to your money. So if you were to invest your cash in the meantime, you might run into trouble. There’s a chance you may not have enough when the time comes to pull the trigger on your significant purchase. This is why you’ll almost always hear financial professionals say that you should never invest savings meant for short-term purchases.
But the world is never this simple, and there’s plenty of gray here that’s worth recognizing. To begin, what is short-term exactly? According to this financial planner, eight years may fall under this bucket.
“If you are going to buy a house in the next eight years, it’s best to keep your money safe in a savings account or CD,” says Anderson of Maranatha Financial. “This will provide access to your money when and if you need it.” —Business Insider
I happen to disagree with this traditional guidance. While the standard advice is to not invest short-term savings, this opinion is not necessarily ideal for everyone. And statistically, it is not great for anyone.
In the article quoted above, Michael Anderson suggests that if you are saving for the down payment on a $600k home, putting the 20% downpayment (about $120k) to work in the meantime would be unwise. But eight years a very long time, so let’s examine the opportunity cost of this decision to not invest short-term savings.
History As Our Guide
Consider this. After five years and with a 2% rate of inflation, your cash will lose about 10% of its value if it sits under your mattress.
However, according to history, about 80% of the time, the S&P 500® Index produced a positive real (inflation-adjusted) return over five years (using extrapolated data going back to 1871). In the median-case, the annualized real return is about 7%, and in the worst-case, the annual real return is about -13%.
Back to our family with $120k in savings for a 20% down payment on a $600k home. Using the stats above, if this family invested just 20% of the down payment ($24k of the $120k) in the S&P 500® Index, the family would have more money about 80% of the time after five years. In the median-case, this family would see a before-tax inflation-adjusted profit of about $9,822; enough to put a sizeable dent into the closing costs of the home.
Indeed, in the worst-case observed, the family would see a loss of about $12,197 after five years. However, this is the worst-case in a period that spans over a hundred and forty years. Further, a high-income household may be able to make up this loss from other income sources. Or the family could target saving $132,197 rather than $120,000. This way, if this worst-case were to occur, the family would still have enough to cover the 20% downpayment.
Is losing $12,197 too much? No problem. Invest 10% rather than 20% of the $120k downpayment. Now the worst-case loss is about $6,099. But there is still a substantial inflation-adjusted upside of about $4,911 over five years in the median-case.
Accordingly, the family has a greater than 80% chance of profit by investing some part of the down payment, with a very low probability of an adverse outcome. Statistically, this is a winning play. And for those with the ability to ride this risk, rolling the dice is sensible.
Of course, this is assuming you plan to hold your short-term savings for around five years. But what if you don’t know when you’ll be buying your house? What if you plan to purchase over the next year? Or next month? In this situation, given a shorter time horizon, you may want to take on less risk and keep a more significant percentage of the downpayment in cash. Even so, it may still make sense to invest a small portion of it, while your capital sits on the sidelines.
And consider this. This one downpayment is unlikely to be the only significant purchase this family will face over its lifetime. Indeed, most families that target a $600k home will likely have short-term savings requirements every few years over decades. For high-income families, there will always be large purchases such as homes, vacations, college, etc.
Accordingly, there may be dozens of scenarios where one family may choose to park all of its short-term savings in cash. Conversely, another family may choose to invest some portion of those savings. Over a long enough timeline (especially those that decide to Invest Forever), it’s clear that the latter family will undoubtedly benefit over the former.
Understandably, according to Behavioral Finance, loss aversion plays a significant role in these choices. And this type of concern alone may lead families to chose the safer option instead of the statistically sensible one. And I get it. For most people, the small chance of losing money may outweigh the higher probability of turning a short-term profit.
Nevertheless, everyone has different risk-tolerances, and a sound financial planning strategy comes down to what is best for the individual. And this all begins with first knowing all of the options that you have at your disposal. Including those that defy conventional wisdom.