INVESTMENTS  -  SHORT-TERM
 
 

Using Mutual Funds and CDs to Meet Your Short-Term Investment Needs
 

Money Market Funds

Money market funds have become respectable investments of late thanks to higher interest rates. While no one is wise to build a long-term investment portfolio around money market funds (or any short-term investment, for that matter), these funds do provide safety of principal and convenience (most fund companies will permit you to write checks against a money fund balance). But savvy investors realize that money funds differ, and that a quick evaluation can uncover higher returns among these otherwise mundane investments. Here are a couple of guidelines:

• The interest paid by money market funds in the same money fund category can vary among fund families. While it rarely makes sense to open up an investment account simply because a particular fund family's money fund is paying higher interest, investors who have accounts with a few fund families should compare yields among the families and concentrate their money market fund investments where a better yield is offered.

• A comparison of after-tax yields will allow the investor to maximize money market fund income. There are four categories of money market funds, each of whose interest is taxed differently:

1.  Taxable money funds that are subject to both federal and state income taxes

2. U.S. Treasury money funds that are subject to federal income taxes, but are generally exempt from state income taxes

3. Tax-exempt money funds that are subject to state income taxes (except for that portion of income attributable to bonds issued in the investor's state), but are exempt from federal income taxes

4. Single-state tax-exempt money funds that are exempt from both state and federal income taxes

Smart investors will compare the after-tax yields on any and all categories of money funds that are available to them. The trick here is to move money into that fund which currently offers the highest after-tax yield.

Short-Term Bond Funds

Short-term bond funds are often worthwhile for investors who can tolerate the risk of a small loss in principal in exchange for greater return potential than is available with money market funds. Short-term bond funds come in a variety of flavors, including corporate, U.S. Government, and municipal. While a decline in principal in a short-term bond investment is possible when interest rates are rising, the losses are generally small since the fund invests only in short-term bonds. (The shorter a bond's maturity, the less its principal value will fluctuate in response to rising or falling interest rates.)

If you are comfortable predicting the near-term direction of interest rates, there is a clear choice between money funds and short-term bond funds. If you think interest rates will rise, money market funds are preferable because the interest they pay rises as interest rates rise. On the other hand, if you expect interest rates to decline or stabilize, short-term bond funds will probably provide a higher return on your short-term money. Those investors who are not willing to make an interest rate bet may well be served by putting part of their short-term money into money market funds and part into short-term bond funds.

CDs

Certificates of Deposits (CDs) are another way to meet your short-term investment needs. They're available in a range of maturities ranging from a few months to as many as ten years. While longer-term CDs are usually a poor substitute for stock and bond funds because, historically, they haven't provided as high returns, they may be useful as a means of meeting your short-term needs. Liquidity and federal insurance up to $100,000 (in a qualifying bank) are two reasons for the attraction of CDs. CDs may be particularly appropriate if you are certain as to when you are going to need the money, e.g., if you plan to buy a car in six months, you can get a six-month CD and know you're going to have the money in hand, plus interest, when you need it. It usually pays to shop around for CDs because some banks are more anxious to get your CD money than others are. You can either check locally or nationally. Barron's, the weekly financial newspaper, publishes a list of top savings deposit yields each week. The interest paid by these banks is often higher than you can find locally. But Massachusetts residents should remember that interest paid on CDs from out-of-state banks is taxed at a higher rate than interest paid on in-state banks.

The Worst Financial Advice Our Parents Ever Gave Us

If you’re middle-aged or better like I am [note: A middle-aged person is anyone who is ten years older than you are at any point in time], you probably remember some financial advice your parents gave you when you embarked on your first real job. It went something like this: “The first thing you need to do with your money is to set aside an emergency fund that is equal to six months worth of living expenses. Keep that money safe in a savings account or checking account so that you can get at it quickly when a financial emergency arises.”

If you were an obedient child, you then spent the next 11 years accumulating your emergency fund while, along the way, the money was languishing in a low-yield savings account.

Now, lest I unfairly malign our parents, who had the best of intentions, their advice reflected the prevailing wisdom of the times. Investing was different back then. Savings accounts were the investment du jour for most smaller investors. It took more money back then to open up a brokerage account, and mutual funds were certainly not the mainstream investments they now are. Also, it usually took more time for you to get your hands on any money you had invested in a brokerage account, which could be problematic in the event of a financial emergency.

But things are different now. You can invest small amounts of money just like a billion-dollar pension fund invests its money. For example, most mutual fund companies will allow you to begin investing in their funds (which typically require a minimum initial investment of $2,500 or more) as long as you’ll agree to let them hit your checking account, savings account, or credit union account for a minimum of $50 to $100 per month. Moreover, you can get your hands on that money in a matter of a few days or, if you live near a branch office of the fund company or brokerage firm, or if you have prearranged with the firm to allow wire transfers to your bank account, you can get access to the money in a day or less.

There’s another way to get your hands on money faster from investment accounts now than you could in yesteryear: you can borrow temporarily from certain employee retirement savings plans (like 401(k) plans) as well as your IRA. Most employers will permit loans from employee retirement savings plans, but the loans must be repaid with interest in order to avoid an early withdrawal penalty. Alternatively, you can withdraw money from your regular IRA so long as you do so only once a year and you replace the money within 60 days. Finally, you can withdraw money from a Roth IRA without penalty and without having to repay the money up to an amount equal to your original Roth IRA contributions.

So there are several ways to get your hands on money quickly at little or no cost if a financial emergency arises. With all due respect to the wisdom of our parents, here is my suggestion regarding an emergency fund: Keep no more than one month’s worth of living expenses in a low-yield interest-earning account for emergency purposes. Give any other money you feel you may need for an emergency a chance to grow since, God willing, you’ll never – or very rarely need to raise a lot of money quickly to meet unanticipated expenses. Where should that extra money go? Ideally, it should be invested in a retirement account that, as I noted above, will allow you to access the money quickly if push comes to shove.

Where should you put your liquid emergency money, the one-month’s worth of living expenses? The highest yield, low risk liquid investment is almost always a money market mutual fund. If you put the money there and get check writing privileges on the account, you can tap into it immediately while, in the meantime, the money market fund will be earning a decent, albeit unspectacular return. It will still beat those savings accounts or checking accounts that our parents used to use for their emergency stash out of necessity since there were no alternatives.

But the most important thing to do is to avoid keeping too much money in low-yield accounts, since they almost always lose ground to inflation after you pay taxes on the interest. Rather, give the money a chance to grow. While my suggestions for investing money that you may need for an emergency may seem a bit trivial, they’re not. If you’re still a doubter, look at the table on page 150 of Your Money Matters.