What is the best way to invest money for 5 years?

Like many people around this time of year, I received a nice little check from the IRS for my 2011 tax return.  I started thinking of all the things I could do with the extra money – a 47″ plasma TV, maybe an iPad, or  some new ice hockey goalie equipment.  You know, the important things in life.  Also on the list of things I want, however, is a luxury condominium with a sweet view of downtown.  Except that costs more than any tax return that I will ever see.   I figure I’ll be ready to buy a home in about 5 years (because 5 year plans never go wrong) and as a result, it is probably about time that I start saving for it.  So I decided to put my big screen TV hopes on hold and put the tax return money towards my future home.  But that was as far as I got before I realized I didn’t know where to put it.

Where should I put money that I need in 5 years?  The 5 year investment is tricky, because it is short enough that you can’t afford the stock market risk like you can with a 20 year investment horizon, but long enough that it would be silly to let it sit in a non-interest bearing account.  There are a couple of basic options out there.  There are your standard savings and rewards checking accounts, Certificates of Deposit (CDs), and finally, investment accounts.  These days savings accounts won’t get you much more than 0.75% APY, and even the best 5 year CD will only get you 1.80% APY – all according to bankrate.com.  (Also check out Smartmoney.com’s take on the best short term investments).  These options don’t even keep up with inflation, so 5 years from now your spending power will actually be reduced as a result of putting your money in these low yield accounts.  If you want the chance of earning interest greater than inflation, you are stuck with investment accounts – which is kind of scary.

At least with the savings accounts or CDs you know that in 5 years your money will actually be there.  But if you invest in stocks and the market goes bad… that luxury condo you’ve been dreaming of quickly turns into a suburban town home.  Just because you open an investment account, however, doesn’t mean that you have to invest in all stocks.  In fact, you probably shouldn’t.  As described in the my asset allocation post, a sound retirement portfolio will include bonds and treasury notes in addition to stocks.  Those who are 40 years from retirement can afford to take on much higher risk (because they have a long time to make up potential losses) and are recommended (according to Vanguard’s target date funds) to invest in 90% stocks and 10% bonds.  Those who are only 10 years from retirement are recommended to invest 66% stocks, 32% in bonds and 2% in cash. You can see the increase in bonds (in blue) as you get closer to the retirement goal in the graphic below from Vanguard’s website.

What asset allocation is best for a 5 year investment?  When I started thinking of the Target Date Fund’s progression to less risky assets, it suddenly hit me.  The 5 year investment is an awful lot like your target date fund investments when you are in retirement.  And think about it: When you are in retirement you certainly can’t afford for your nest egg to take a big hit in the market, but you need continued appreciation to try and live off the nest egg’s interest.  So what exactly does an in-retirement asset allocation look like?  I went straight to Vanguard’s website and copied down the asset percentages for the 4 funds shown below.  On the chart, the risk and expected rate of return decreases from left to right.  I’ve included two target date funds that have a target retirement date close to 2012 just as a comparison, but it is the allocation percentages from the Vanguard In-retirement fund (VTINX) that you will want to use.  While I was looking on the website I came across Vanguard’s “Life Strategy” funds, which believe it or not, have a fund specifically designed for 3-5 year investment horizon (VASIX).  This would also be an reasonable asset allocation, though it is more conservative than VTINX;   likely due to to the fact that that it is meant to be used to save for something as soon as 3 years away.

What kind of return can I expect from these funds? Keep in mind that because this is an investment in the stock market and bond market, there is no way to predict your annual yield over 5 years.  BUT, based on the asset types in each fund we can make an educated guess about what kind of returns to expect over the long run – like 20 plus years.  I know in some ways that is not helpful because we are looking at a 5 year window, but that is the best we can do; it is impossible to predict an investment’s 5 year return with any accuracy.  With that said, over the long run, I figure that these funds will average a 4% return annually.   Why is that? The goal of most in-retirement funds (at least Vanguard’s) is to get a 4% return.  The idea is that while in retirement, you can spend 4% of your nest egg every year, but by earning 4% through investments, your nest egg never loses value.  Since Vanguard advocates for using the 4% rule in retirement planning calculations, I have assumed that their retirement investments (such as VTINX) are structured to provide roughly the same return.  As it turns out (see graph below) VTINX has actually averaged a 5.30% average annual return since its inception (which was only 8 years ago so the numbers don’t mean that much).

Morningstar.com provides the actual (not average) annual return in each year since 2003.  This look shows how volatile the annual yield can be, ranging from  negative 10.93% in 2008 to a positive 14.28% return in 2009. What I’m trying to say is this:  if you invest in VTINX and keep it for 30 years, your average annual return would probably be around 4%.  However, it is entirely possible that for the 5 year window between 2012-2017 (when you own the fund) the fund would have an average annual return of 10%, or even 1%.  It is riskier than a CD, for sure,  but it is certainly well managed risk.  And besides, 4% return on my investment sounds pretty good to me, especially when I can only get 1.8% with a CD.

OK. You’ve convinced me.  But I don’t have an investment account, so what do I do? It is pretty easy:

  1. Open a Vanguard or Schwab investment account.  Make sure that you are opening an investment account and not a retirement account like an IRA, Roth IRA or 401(k).  Why those two firms? Both Vanguard and Schwab allow you to buy their brand of ETF index funds (which have the lowest expense ratios) for free.  FOR FREE!  There are no other investment firms out there with this kind of access to index funds, and as explained in my Target Date Fund Series, I think buying index funds (not individual stocks) is the smartest thing you can do.  In addition I’m consistently impressed with the advice and service that I get from both these firms (yes, I have accounts at both).
  2. If you open a Vanguard account and are going to invest more than $1,000, then you can simply buy the VTINX ($1,000 minimum) or VASIX ($3,000 minimum) fund mentioned above.  If you are starting out with less money you will have to buy 3 or 4 index fund ETFs to mimic the asset allocation of either VTINX or VASIX.  But don’t worry, I’ve made it easy for you – take a look at the chart at the bottom of the post.  It gives you the symbol of the ETF you should buy (right hand side) along with the percentage of your investment that you should spend on each ETF.   Two quick notes if you want to mimic the VTINX asset allocation: First, To put 5% in cash, you won’t have to buy a particular fund, just leave 5% of your savings unspent in the account.  Second, if you have a Vanguard account they don’t have an ETF for inflation protected securities, so just put that extra 20% in the BND fund.
  3. Keep adding to your investment account (use the same percentages detailed in step 2).
  4. Rebalance every year.
  5. Buy a home! (or whatever else you have been saving for)


Apartment Hunting 101

It is that time of year in Boston when everyone and their mom is out looking for an apartment.  And I mean that literally because all those undergrads who are starting their Freshman year at one of the many Boston area schools really are apartment hunting with their moms.  With so many people looking for apartments, it is definitely not a renter’s market and you have to do your research before jumping in.  Over the past four years I’ve moved five times within the Boston area, and I like to think that I’ve learned a few things about apartment hunting in the area. I figured it was worthwhile to devote a post to answering some of the financial questions that I struggled with along the way.

How do broker’s fees affect my monthly rent? One of the first things you’ll notice when you go on Boston’s craigslist is that everything is sorted by “fee.”  Generally, there are three categories: no fee, half fee, and whole fee.  In order for a landlord to list an apartment with any real estate service, the real estate service charges a “fee” that is equal to one month’s rent. Sometimes the landlord will pay this fee himself (no fee), sometimes he will pay half (half fee) and sometimes will pass the full cost on to the future tenant (whole fee).  Obviously, finding an apartment with no fee is the best situation, but you would  really be limiting yourself if you only looked at no fee apartments.

Because this fee is paid upfront, it doesn’t really affect your monthly rent, but it does affect how much you will pay for that apartment over the course of the year.  I wanted to be able to compare apartments “apples to apples” regardless of whether they had a fee or not.  In other words, I wanted to incorporate the broker’s fee into the monthly rent as an easy way for me to see how much each apartment really cost.  This can be pretty easily estimated for apartments in the $1,200 a month range (adding a whole fee will increase your rent by $100 dollars a month), but I hate doing mental math – especially when I’m under pressure – so I made this spreadsheet to take along with me while I was apartment hunting.  (I know – Dork alert!)

How should I compare apartments with included utilities?  You’ll notice in the spreadsheet above that I’ve added columns for apartments that include “heat and hot water” and that include “internet.”  Many of the area’s brownstone apartments (i.e. non triple decker houses) include heat and hot water in the rent.  This is an important factor because it can reduce your monthly rent by $100 (my approximation).  Now I’ll admit that its rare to find apartments with internet included, but it is not uncommon in some luxury rentals.  I’ve come across craigslist ads for $2,000 a month luxury apartments with heat, hot water and internet included AND no fee.  When you take all that into account, you are really only paying $1,825 a month.  That would be slightly cheaper than an apartment advertised at $1,700 a month with a full fee and nothing included (actual rent would be $1,842). The lesson here is loosely define your “maximum” in the search parameters because you may find a good deal on an apartment that initially seemed to be out of your price range.

How much money should I have available for apartment hunting?  One of the most important things about apartment hunting this time of year is that you have to be able to act quickly.  If you see an apartment you like, you need to be filling out the application and signing a lease and within an hour.  Bring your check book, because the up front cost of renting an apartment can be quite high – check out the spreadsheet below.  At a minimum, all landlords will require either first and last month’s rent, or first month’s rent and a security deposit (equal to one month’s rent).  That cost can double though if you have to pay a full fee along with first month’s rent, last month’s rent AND a security deposit.  While you technically get everything but the broker’s fee back, it can be hard to get all that money into your checking account on short notice, so make sure you plan ahead.

What happens to my security deposit?
  As a responsible adult (and no longer a cleaning impaired college student), I fully intend to receive my entire security deposit back at the end of my rental period.  Because I expect to get it all back, it was upsetting to think that my money was just going to sit under the landlord’s mattress when it could be earning interest in my bank account.   But as I was carefully reading my lease before signing (which stated that I am required to help the landlord with snow removal…), I found this little gem:

“As required by law, the security deposit is presently or will be held in a separate, interest-bearing account.  If the security deposit is held for one year or longer from the commencement of the tenancy, the Lessee shall be entitled to interest on the amount of the security deposit at the rate of five percent (5%) per year, or such lesser amount as may be received from the bank, payable at the end of each year of the tenancy.”

And right below that paragraph (this is all from the Greater Boston Real Estate Board standard lease form) is another paragraph stating that the tenant is also entitled to 5% interest on the last month’s rent as well!  The caveat here is that if the landlord puts the money in a bank that gets .01% interest, then that is what you are going to get.  But, in the standard form lease, there is a line that requires the landlord to enter the bank name and number of the account in which he or she is depositing the money.  I have a hunch that many landlord’s do not fill this part out completely, and if that is the case, it seems like you should be entitled to the 5% interest – if you feel like calling them on the technicality.  Regardless of what happens, its nice to know that the Commonwealth of Massachusetts is looking out for your best interest… (ha ha).

Topics Introduction

  • Budgeting – Mint.com, goal setting and other ways of thinking about making budgets
  • Credit Cards – Finding the best card, everyday actions that affect your credit score and more
  • Investing – Researching investment theories and finding good brokers
  • Post Grad – All the advice that I wish someone gave me after I graduated from college
  • Rent vs Own – Personal musings and research on whether I should ever own a home
  • Retirement – Figuiring out how you should be saving and how much