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Short-Term Investments: What to Know

Short-term investments give those with a small time horizon a way to gain returns while sheltering their funds from risk. We explain how these securities work.

For many, investing means playing the long game until our goals are met. This is especially true if your goals are lofty or take a while to attain, such as retirement or paying for a child’s education. However, other cases call for shorter-term investments, such as a certificate of deposit or a money market account.

This article will give you an overview of what constitutes a short-term investment and when one might gravitate toward using one. This includes examples of various types of securities and accounts that fit into this category. You’ll also learn about the benefits and risks of short-window investments.

Key Takeaways

  • Short-term investments are securities an investor holds for five years or less and, often, is sold within a year of owning it.
  • Investing in short-term securities shields one from risk by offering higher liquidity and fixed-returns.
  • While useful for those with a short time horizon, these types of investments offer modest returns compared to their long-term counterparts.
Stacks of Coins Getting Bigger Next to a Clock

Definition of a Short-Term Investment

Short-term investments are those that one may easily convert to cash if the need arises. An investor typically focuses on these when they must reach a goal within a relatively small timeframe or if they simply want near-liquid assets in their portfolio. In many cases, investors sell these investments within three months to a year of holding them. However, the range for a short-term asset is typically a holding period that falls within five years.

“Investing in short-term accounts or securities provides liquidity, allowing investors to access their funds relatively quickly compared to long-term investments,” explains Taylor Kovar, CFP, founder and CEO at 11 Financial. For investors, investing in short-term assets lets them manage their cash flow and save for goals in the short term. “This liquidity can be essential for covering unexpected expenses or taking advantage of new investment opportunities,” Kovar adds.

Because of their liquidity (or near liquidity), it’s standard for a short-term investment to have less risk than a long-term one. However, this also means smaller returns as a result. An investor will typically allocate their funds here for a fixed return over a certain period.

As an example of the above, consider a situation where someone invests $20,000 into a money market account at a 4.2% interest rate. While the returns over a year may not be huge (about $840), it allows one to safely earn money while keeping their funds liquid.

Reasons to Invest for the Short-Term

Short-term investments afford investors the benefit of keeping their funds liquid or near liquid. This, coupled with the benefit of earning modest returns at a relatively low risk, makes them ideal for individuals who are looking ahead to short-term goals or who would like to manage risk.

“Short-term securities are perfect for when you know you’ll need cash for some future expense, but you want to put it to work in the meantime,” shares Keith Spencer, CFP, founder and financial planner at Spencer Financial Planning. He adds that a prominent example “might be if you’re planning on purchasing a home a year from now and you have most of the down payment saved up already. In that case, it might benefit you to put the cash in a short-term vehicle to earn you extra interest in the meantime.”

A primary reason for parking your money in a short-term security, according to Spencer, is “that you want safety.” Investing in a short-term asset, because of its liquidity and generally fixed returns, shields you from risk in a way that a long-term one doesn’t.

Pros and Cons

Short-term investments, such as money market accounts and certificates of deposit, give investors the chance to earn fixed returns while keeping their funds relatively liquid. This makes them a popular choice to plan for short-term goals, such as buying a house or paying for a dream vacation. However, these securities also have downsides to be aware of, including a lack of any large returns and a vulnerability to volatile market conditions.

As mentioned, the primary benefit of short-term investments is the ability they grant investors to shelter their money from risk, while also gaining returns on it within a small timeframe. Because of their low risk, these types of assets are often “more suitable for conservative investors or those with a shorter time horizon,” says Kovar. For instance, one who’s set to retire in less than five years may be more inclined to opt for short-term investments than someone who just began their career.

On the flip side, short-term investments don’t bring much in the way of yield. This is, in part, because of their low-risk, fixed nature. This can cause your money to “not keep pace with inflation” over time, Kovar cautions. You should also be aware that short-term securities “may be more susceptible to market volatility and economic downturns, leading to fluctuations in value and increased risk.” Finally, such assets may also include “higher transaction costs or fees, reducing overall returns for investors,” Kovar points out.

Pros

  • Less risk than long-term investments
  • Fixed returns that are often based on a set interest rate or term.
  • Liquidity.

Cons

  • Returns are modest, especially given any additional fees or transaction costs.
  • Inflation may cut down the value of your returns.
  • Vulnerability to volatile market conditions.

Types of Short-Term Investments

A short-term investment is a security that grants a person liquidity, while also providing returns over a specific period. This type of asset can take on many forms, including an account at a bank, a bond, or a money market fund. Below is a list of the most common types of short-term securities:

Certificates of Deposit (CDs)

CDs are a savings account that requires you to set aside an amount of money for a fixed term. During this period, you’re unable to withdraw your funds without incurring a penalty. However, the tradeoff is that you’re typically able to earn more interest than with a traditional savings or money market account.

Money Market Accounts

Money market accounts, offered by both banks and credit unions, allow you to deposit funds at a higher interest rate than a typical savings account. However, while not completely preventing withdraws like a CD, these types of accounts limit the number of transactions you make. Additionally, you typically can only withdraw funds via a check, ATM, phone call, or at a bank, rather than online.

Money Market Funds

Not to be confused with the previous example, money market funds are a type of mutual fund that exclusively buys, holds, and sells short-term investments.  With these, you can earn both interest and capital gains after selling your shares for a profit. You can buy these through a traditional brokerage account or a tax-advantaged retirement account, such as a Roth IRA.  

Treasury Bills

Treasury Bills (T-Bills) are short-term investments that allow you to buy a note that, in turn, will mature after four weeks to one year. Once it matures, you can cash it in for a profit.

Bonds

Much like T-Bills, bonds are securities that provide you with a fixed income after a set maturation period. This term varies depending on the type of bond you buy, however. A bond with a relatively small maturation period fits within the short-term investment category because it provides a set amount of income, can be sold at any time, and presents minimal risk.

Choosing Short-Term Investments

There are a wide variety of short-term securities that may be beneficial for you; however, to select the right one, it’s important to consider both your goals and risk tolerance. For example, money market accounts are typically FDIC-insured and offered by large financial institutions, making them very low risk, but with a modest reward. On the other hand, CDs offer higher interest rates, but they prevent you from withdrawing for a fixed period.

Taylor Kovar, CFP recommends that, to find the right short-term investment, you “should assess the investment’s liquidity and determine how quickly [you] can access [your] funds if needed.” As mentioned, some short-term assets, such as CDs or bonds, are more difficult to sell off without losing money. Kovar adds that “investors should evaluate the investment’s risk profile and potential returns, weighing the trade-off between risk and reward. It’s essential to diversify short-term investments across different asset classes and industries to mitigate risk and enhance overall portfolio stability.”

Before investing in short-term securities, we recommend you have a financial advisor in your corner. They will help you avoid mistakes and work with you to build a portfolio that tightly aligns with your goals. To find one near you, consider using this free matching tool, which will connect you with a local professional that suits your needs.

Frequently Asked Questions

Is it worth putting money in a money market account?

This depends on your goals, risk tolerance, and time horizon. Money market accounts offer higher interest rates than traditional savings, but it is a bit more difficult to withdraw funds. Additionally, you may not see as much gain as with a CD or other short-term investments. We recommend consulting with a financial advisor to select the security that’s right for you.

What is the main benefit of short-term investments?

Short-term investments allow investors to shield their funds from heavy risk, but also gain modest returns in the meantime. This is ideal when one has a short time horizon and would like to keep their money accessible and safe from significant losses.

Do short-term investments have a higher capital gains tax rate?

If you sell an investment for a profit within one year of holding it, you are subject to short-term capital gains tax. In this case, you’ll pay a rate equal to your ordinary income tax rate. This rate is higher than long-term capital gains tax.

Is a bond a short-term investment?

A bond can be a short-term investment if its maturation period is five years or less. Additionally, these securities fit into this category because of their ability to provide fixed income at a relatively low risk.