The development of an appropriate short-term asset allocation is an often overlooked but important aspect of financial planning and should be addressed as part of a comprehensive savings strategy. Maintaining adequate savings allows you to recover from temporary setbacks, such as a job loss, and pay for unexpected expenses without dipping into retirement savings or testing the upper limits of your credit card. A linchpin of financial stability, a thoughtful short-term asset allocation provides the security needed to optimize your long-term planning objectives.
The key to a sound asset allocation strategy- be it short or long term- is to understand what the funds will be used for and when that need will likely arise. In matching savings to cash flows, you can ensure that you are utilizing the most appropriate type of savings or investment vehicle to meet your needs.
An emergency fund is the foundation of any financial plan and represents money that is set aside to cover unexpected expenses or to pay ongoing living expenses in the event of a job loss. Determining the amount to set aside begins with establishing a budget that accurately represents your monthly spending, and also includes large and recurring expenses such as insurance premiums, vacations, recreational activities, holiday expenses, and gifts. Remember to update your budget at least once per year to ensure that your emergency fund keeps pace with your expenses.
Next, consider your potential exposure to a job loss, large repair bills, medical expenses or other budget-busting outflows. The amount of emergency savings needed by those in volatile industries with frequent layoffs is much higher than for those with stable careers. A few thousand dollars may be sufficient for those with very stable employment and with little risk of incurring unexpected expenses, while maintaining a year or more of salary plus expenses in liquid savings may be wise for those not unaccustomed to receiving a pink slip.
Although the name is unambiguous, it’s important to remember that an emergency fund is for emergencies. Frequent use of your emergency fund to pay for non-emergencies is evidence of poor budgeting and should prompt a review of your expenses. Emergency savings should, of course, be available when needed, and should not be affected by the vagaries of the stock market, but should not be commingled with your checking account where they can be used for impulse purchases or non-essential expense. Maintaining a dedicated emergency saving account with a separate bank, and eschewing the conveniences of online banking or a debit card, is one way to keep your impulses at bay and ensure that the funds are available when they’re needed.
Having an understanding of what an emergency fund is and is not, is a helpful first step in determining when to set it up and how to invest it. Given its role in providing immediate liquidity to cover immediate needs, its funding should take precedence over funding long-term goals, including retirement. While funding short and long-term goals can occur simultaneously, and ensuring that 401(k) matches or other employer-provided funds are captured is an important consideration, the trajectory of accumulation should be skewed to meeting one’s immediate needs.
Absent those with the faculty of clairvoyance, the timing of when emergency funds will be needed is unknown. Given this unfortunate limitation, high yield, but fully liquid, savings accounts and money market accounts are a good choice for your emergency savings. These accounts carry Federal Deposit Insurance Corporation (FDIC) coverage on deposits up to $250,000 per depositor, per account type, and up to $500,000 in joint accounts where both owners have equal withdrawal rights. To find the best rates, use online comparison tools, such as the savings account comparison feature available at Nerdwallet. Be sure to review the account at least once per year to ensure that you are maintaining an adequate balance and are earning a competitive return on the funds.
Short-Term Savings (less than 2 years)
Money needed in less than two years can generally be allocated in a similar manner to emergency savings, but if you know the exact date when the money is needed (or have a good approximation), certificates of deposit may also be a good choice.
Certificates of deposit (CDs), or share certificates, are deposits that you make with a bank or credit union for a fixed period of time in exchange for a set rate of interest. The interest rate for a CD is generally higher than offered in a saving or checking account but does carry a few risks worth noting. While FDIC insured, they are not fully liquid until maturity and if interest rates should increase during the term, the owner will lose out on the opportunity to earn a higher yield elsewhere. Those considering CDs should be mindful of these risks and decide whether the additional interest rate offered is sufficient compensation. A CD may be a great option for those that can closely match the maturity date of the deposit with the date that the funds are needed.
Short-Term Savings (2-5 years)
A longer time horizon opens up some additional opportunities for your savings, including longer duration certificates of deposit, U.S. government treasury notes, and short-term bond funds.
United States treasury notes can be purchased commission free at Treasury Direct, pay interest every six months, and are issued with maturities of 2, 3, 5, 7 and 10 years. Also on offer are short-term treasury bills with maturities ranging from a few days to one year, which may be used to bridge the gap between the maturity of treasury notes and when the funds are needed.
Short-term bond funds represent another option and are comprised of a mix of investment grade fixed-income securities with an effective maturity of under four years. These funds may offer attractive yields, but be wary of hidden fees and the potential for loss of principal. When considering bond funds, look for those with ultra-low fees and be sure you understand how sensitive the investments are to movements in interest rates. Interest rate risk can be quantified by researching the fund’s average duration, which measures the increase or decrease in the bond fund’s price given a 1% change in interest rates. For example, a bond fund with an average duration of 3.5 years would expect to see a 3.5% decrease in value if interest rates were to increase by 1%. Conversely, the fund’s value would increase by a similar magnitude if rates were to decline by 1%. Understanding this relationship and the fund’s sensitivity to interest rates can help you avoid risky funds masquerading as safe investments.
Whether saving for a rainy day or a specific goal, it is important to review your short-term asset allocation periodically to ensure that it continues to meet your needs. Emergency fund balances may need to be replenished or increased to account for changes in your lifestyle, and specific savings goals are likely to change over time. A review of your plan should include an evaluation of your goals and objectives, as well as considering whether the specific short-term investments you have selected remain the best options to serve your needs.
John Male CFP®, RICP®
The Gassman Financial Group
G&G Planning Concepts, Inc.
9 East 40th Street, 5th Floor
New York, NY 10016
T: (212) 221-7067 Ext. 113
F: (585) 625-0830