How to Invest for Anticipated Near-Term Expenses
A common guideline in personal finance states that money needed in the next few years shouldn't be invested in the stock market. Instead, funds for near-term expenses should be held in safe, short-term assets.
While protecting your capital is important for anticipated expenses, defensively hoarding cash can often be just as risky as investing it—especially if you haven't actually accumulated enough money to meet your goal yet. To successfully prepare for expenses occurring within the next decade, investors need to view near-term planning not as a one-size-fits-all rule, but as a calculated tradeoff.
The Core Tradeoff: Capital Preservation vs. Capital Appreciation
Fundamentally, figuring out how to fund near-term expenses requires balancing two competing goals:
Capital Preservation is about protecting your assets, ensuring that every dollar you need at some future date will be waiting for you when you get there. It involves setting aside funds for anticipated liabilities in investments that have little to no chance of decreasing in value. Because you are minimizing risk, you are also minimizing returns. The "cost of safety" is that your money will generally just keep pace with inflation rather than truly growing. (For ways to invest for capital preservation, see Appendix 1.)
Capital Appreciation is about growing your assets, especially if you don’t have enough cash saved yet to cover the expense. It requires investing in some amount of equities in order to outpace inflation, typically a mixture of stocks and bonds. Because these assets fluctuate, you are accepting some amount of market volatility. “Safety” in this world is achieved by growing your assets to be able to cover the future liability. This safety comes at the cost of patience and flexibility; if the market drops, you may need to delay the expense and let the portfolio recover. (For ways to invest for capital appreciation, see Appendix 2.)
For each anticipated expense in the next decade, you need to figure out which side of the tradeoff you should favor. To strike the right balance between safety and growth, here are five key questions to ask yourself about your anticipated expense.
Question 1: How far away is the expense?
The timeline of your expense is the single biggest factor in determining your risk capacity. Market downturns typically take a few years to recover from, so shorter timelines necessitate less exposure to market volatility.
How to Answer: Look at the year you anticipate needing the cash.
Is it in 3 years or less? A market drop in that timeframe gives you very little time to recover, so safety is paramount. Lean toward capital preservation.
Is it in 4 or more years? You are entering the window where you have enough time to ride out typical market corrections and recover from potential dips. Lean toward capital appreciation.
Question 2: How much of the expense is already funded?
Sometimes you are saving for an expense that significantly exceeds the capital you have saved to date (such as a down payment), while at other times you might already have the money you need (such as the taxes on the sale of a house). How you invest those funds depends heavily on whether you've already hit your target or still need your money to grow.
How to Answer: Compare your current savings to the amount of the anticipated expense.
Are you already fully funded? If you have already saved enough money to fully cover the expense, there is less of a need to prioritize growth. Lean toward capital preservation.
Do you face a significant shortfall? If you don't have enough money to meet the goal yet, you’ll need a higher rate of return to outpace inflation and bridge the gap. Lean toward capital appreciation.
Question 3: Can the expense be delayed if needed?
Your ability to be flexible with your timeline acts as a hidden safety net. If you don't have to spend the money on a specific date, you can afford to take on more risk, as you can simply wait out any market downturns.
How to Answer: Determine the rigidity of your deadline.
Is the deadline fixed and non-negotiable? If the timing is inflexible (i.e. tax bill, college tuition, debt repayment, etc), you don’t have the luxury of "wait until the market recovers." Lean toward capital preservation.
Is the timeline somewhat flexible? If the expense is discretionary (i.e. vacation home, boat, early retirement) and you are willing to delay it by a few years if the market is down, that flexibility is your safety net. Lean toward capital appreciation.
Question 4: How certain is the expense?
If the expense isn’t a sure thing, or if the timing is a moving target, that ambiguity increases the need for growth. The longer your money sits waiting for an uncertain event, the more vulnerable it is to inflation, making growth increasingly important.
How to Answer: Evaluate the predictability of the expense.
Is the expense a near certainty? If you are confident in the necessity and timing of the expense, your investing window is fixed, and you should play it safe. Lean toward capital preservation.
Is the expense a "maybe"? If the expense has a decent chance of slipping out (or not happening at all), your money might be stuck in limbo for a long time, losing purchasing power to inflation. This ambiguity increases the need to prioritize growth. Lean toward capital appreciation.
Question 5: What happens if I fall short?
Risk tolerance isn't just about how you feel when the market drops; it's about the real-world consequences of having less money than you planned for.
How to Answer: Consider the worst-case scenario in a market downturn.
Is the cost of failure significant? If there are serious repercussions for not being able to cover the full expense due to a market retreat (such as defaulting on a mortgage or dropping out of college), you need to minimize your exposure to market volatility. Lean toward capital preservation.
Is the expense discretionary or adjustable? If the worst-case scenario simply means you take a smaller vacation, buy a used car instead of a new one, or put down 15% instead of 20% on a house, you have the risk capacity to aim for higher growth. Lean toward capital appreciation.
Decision Checklist
Lean Toward Capital Preservation If:
☐ The expense is anticipated within the next 3 years.
☐ You have already saved most of the needed funds.
☐ The deadline is rigid and non-negotiable.
☐ The expense is reasonably certain and unlikely to slip.
☐ The penalty is high if you’re unable to cover the full expense.
Lean Toward Capital Appreciation If:
☐ The expense is likely 4 or more years away.
☐ You need to grow your savings in order to reach your target.
☐ You can delay the expense if the market drops.
☐ The expense is somewhat ambiguous or might not happen at all.
☐ The expense is discretionary or adjustable.
Appendix A: Investing for Capital Preservation
If your answers lead you toward Capital Preservation, you need to prioritize near-term safety over growth. The investments in the table below are all extremely safe, with little chance of losing value. Choosing between them comes down to the timeframe of the expense, and your preferences with regards to liquidity or locking in a rate. Just know that none of these investments will provide much growth beyond inflation, and therefore become more risky at longer durations.
| Investment Vehicle | Expense Timeframe | Benefits | Drawbacks |
|---|---|---|---|
| High-Yield Savings Accounts (HYSAs) | 0 – 2 yrs | Instant liquidity; zero market volatility; FDIC insured. | Variable rates (yields drop when the Fed cuts rates); fully taxable. |
| Money Market Funds (MMFs) | 0 – 2 yrs | Aim for a fixed $1.00 net asset value (NAV); SIPC insured or backed by safe debt. | Variable rates; generally fully taxable (unless using a municipal MMF); slightly less instant than an HYSA. |
| T-Bill & Ultrashort Bond ETFs | 0 – 2 yrs | Highly liquid; very low credit risk. | Variable rates; cash takes a day or two to settle to your bank. |
| Short-Term Bond ETFs | 1 - 3 yrs | Generally offers slightly higher yields than pure cash equivalents. | Introduces a small amount of interest rate and credit risk. |
| Certificates of Deposit (CDs) | 1 – 5 yrs | Locks in interest rate for a set period, protecting against Fed rate cuts. | Locks up cash; subject to early withdrawal penalties if withdrawn early. |
Appendix B: Investing for Capital Appreciation
If your answers lead you toward Capital Appreciation, you need to trade some near-term safety for growth. This means allocating at least some of funds to equities (stocks), with the remaining funds allocated to bonds. Determining an appropriate mix of stocks and bonds for a given liability is not an exact science, and depends on your answers to the questions outlined above.
For example, let’s say you have $50k that you are saving for a down payment in the next 5-10 years. Because this expense is not fully funded, is still a way out, and isn’t set in stone, you know you can’t just focus on capital preservation. But how much of the $50k do you put into stocks vs bonds?
To come up with an answer, we can use the questions above:
How far away is the expense? If the down payment is likely to be closer to five years, you might need more bonds, maybe a 50/50 stock/bond allocation. If closer to 10 yrs, you might aim for a 90/10 split. (Remember, if the liability is 10+ yrs away, the funds should be 100% in equities.)
How much of the expense is already funded? If we already have 80% of the down payment, we might lean towards more bonds with a 40/60 allocation. If instead we only have 50% saved, we will need to lean heavily into equities, such as a 80/20 allocation.
Can the expense be delayed if needed? If we really want to get into a home sooner rather than later, more bonds would be justified. If instead we would be fine with delaying our home purchase a few years in a down market, we might want to tilt more aggressively towards equities.
How certain is the expense? Since a down payment is inherently discretionary (no external deadline) and might not happen at all under certain conditions (losing a job, health challenges, etc), a more significant equity allocation could be acceptable.
What happens if I fall short? While you may be disappointed if you aren’t able to buy a home on your preferred timeline, you are unlikely to face severe consequences from missing your target (like defaulting on a loan or needing to declare bankruptcy). Because of this, taking on more equity is a possibility.
Each of these questions will nudge your potential stock/bond allocation for the $50k in one direction or the other, helping you arrive at an allocation that makes sense for your specific situation.
