I keep telling everyone that for long-term goals, it’s best to have an investment plan that has a major equity component. But what about the goals that are not decades away and rather just a few years away?
What are the saving and investment options for such short-term financial goals?
Before we proceed, we need to define what short term is.
What exactly is Short Term?
There is no standard definition. Everyone has their own.
But you can say that financial goals that are less than 5 years away can be considered to be as short-term goals. Many of you may feel that period of 5 years is too long to be categorized into short term. If that’s the case, then maybe you can accept 3 years as a reasonable definition of the short term. Happy? 🙂
Even within this 3-5 year period, not all goals are alike. Some are NEEDS and some are just DESIRES. Some are critical and some are good-to-achieve. (Here is a solid post on finalizing your financial goals and a free excel sheet for financial goal planning.
So the approach to save for different short-term goals may differ (if you are willing to do it diligently). Or else, one can always justify keeping things simple.
But for the sake of bringing more clarity to your short-term goal identification and prioritization, you can map your goals in the below grid:
As might be clear from above grid, once you identify and grid your goals as above, you can adopt different investment plans for each if need be.
Now since we are talking about short term investments, you cannot afford to take huge risks by investing all your money in assets like equities, etc.
For critical goals that you can neither delay nor downsize, taking risk can be stupid. For example – the goal of paying for your house downpayment after 1.5 years. But for good-to-achieve goals (like foreign trip after 3 years), you can still take some risk if you feel comfortable with it. But even then, taking too much risk is once again…stupid.
One important thing to understand is that when it’s about short-term goals, it means we are concerned about just a few years. So a small difference in returns (earned by taking higher risks) may not be too beneficial, as the power of compounding doesn’t work much in small periods. So why take too much risk??
The idea mainly is to save and invest in a way that there are little to no fluctuation in returns and absolutely no loss of capital. Any loss of capital that happens (if a risky investment is made) has very less time to recover. This is the reason why equity is not suitable for short term goals.
Saving & Investment option for Short Term Goals
So let’s see what are some of the useful saving (investment) options for short term goals:
Bank Fixed Deposits
This is the obvious choice for most people.
The interest rates are typically 6% to 8% per year. FD rates in India vary from one bank to other, but not by a lot. So do check out which bank is best for fixed deposits. It’s another matter that you don’t want to end up opening relationships with several banks every year in search of best FD interest rates. 🙂
But the interest on FDs is taxable and hence, pre-tax and post-tax returns for fixed deposits are different. Post-tax FD returns will generally not even beat inflation. These are best suited for periods less than 3 years. It’s also good for parking some money as an emergency fund.
RDs are also very popular and do not need any special introduction.
If you are a conservative saver and do not have the lumpsum amount to put aside, RD can come to your rescue. It allows regular periodic savings. But like FDs, the interest on RD is taxable and lowers your post-tax returns. It’s still good for saving up for near-term goals systematically.
Now that was briefly about FDs and RDs.
But what about the alternative to fixed deposits FDs? What are other possible options if you wish to save (or invest) for short term? Are there better investment alternatives than fixed deposits that offer better returns than FD?
Ofcourse there are. But they come with their own set of risks. Let’s see these options.
Debt funds are slightly riskier than bank deposits but allow you to take a shot at somewhat higher returns. In good years, top debt mutual funds can do quite well.
These debt funds come in various varieties like liquid funds, ultra-short term funds, short-term debt funds, etc. But each one is best suited for a different purpose.
Generally, liquid funds are best suited for parking money for few months. Ultra short term funds are good for upto a year or near abouts. For more than that, short term debt funds are good enough.
Debt funds are fairly safe but some risk is always attached while investing in these type of funds. Do not expect bank FD type zero-volatility here. That is the major difference between debt funds and fixed deposits. Liquid funds are least risky among these. Then come ultra-short term funds and then short-term debt funds.
Debt funds though more tax-efficient than FDs, aren’t tax-free. If redeemed before 3 years, capital gains tax has to be paid. If held for more than 3 years, capital gains tax is applicable but with indexation benefits. And this is where debt funds win over fixed deposits if you check out any FD vs debt fund calculator. But debt funds can be looked at for even less than 3 years. Ofcourse choice and category of debt fund will matter.
I must say here that debt funds are gaining popularity these days. And rightly so. But FDs too are decent enough for periods like less than 3 years (ofcourse you need to consider interest rates). But for many, peace-of-mind is more important than post-tax returns. 🙂 And to be blunt here, most people give unnecessary importance to tax saving where there are other bigger financial decisions to get right.
I suggest that you do not go big bang into using debt funds if you do not have an idea of how volatile they can be. Slightly lower returns in FD (that too not everytime) is still fine as the period in question is small.
Corporate Fixed Deposits
With bank FDs giving low returns, many people get attracted to high-interest corporate FDs. These are just like bank fixed deposits but the difference is that you are parking money with a corporate and not the bank. Also, for the additional risk that the saver is taking, corporate FDs offer higher interest rates than bank FDs. Usually, company FDs offer 2-3% higher than bank FDs.
So for people who are unable to look far beyond bank FDs (and have no experience of debt mutual funds), corporate fixed deposits do offer an attractive investment option.
But do not ignore the risks just because these FDs are offering higher interest. Always scrutinize the credentials, credit rating (stick with AAA types) and repayment record of the company before handing over your hard earned money to them.
Don’t be too adventurous in your greed to earn a percentage point more here or there. There have been cases of defaults by companies offering FDs too. You don’t want money planned to be used for your short-term goals stuck up anywhere. Isn’t it?
Debt Oriented balanced Funds
If you want to be adventurous (and most people shouldn’t be) and are investing for not-so-critical goals that are more than 3 years away, you can even consider investing a small part of the money in debt-oriented balanced funds.
These have a small exposure to equity so there is a possibility of getting little extra returns. But I assume you know the risks with equity. It can even go against you and at times, returns might be lower than fixed deposits too!
Want to Earn More (by taking More Risk)?
This is not advisable for most people.
- If you insist, and
- You are aggressive (even though the time horizon is not suitable for aggressiveness), and
- Your goal is more than 3 years away
then, you can take slightly higher risk. I repeat this may not be suitable for everyone.
For short-term goals and where you are willing to take higher risks as the goal is not very critical, you can take some equity exposure (like 20-30%) and stick with debt options for the remaining 70-80% of the investment amount. But as the goal day approaches, you should reduce your equity exposure.
In a way, this approach is similar to investing in debt-oriented balanced funds. But it allows for more control as you can control the amount of equity that you wish to get exposed to.
What about Recurring Short term Financial Goals?
There are some short-term goals that are recurring in nature. Like saving for travel (holiday), school fees or electronic purchases.
Obvious and natural reaction to such goal is to go for Recurring deposits. But one can also consider some varieties of debt funds for such goals too depending on the frequency of goal recurrence.
What to do when Long & Medium term goals become Short term goals?
This is bound to happen one day or the other.
Suppose you began investing for a goal that is 15 years away. Initially, you took 70% equity exposure. Now let’s say 10 years have passed. So what should you do?
A theoretical approach would be to reduce your equity exposure continuously:
- 5 years left (11th year since investing): 60% Equity + 40% Debt
- 4 years left (12th year since investing): 40% Equity + 60% Debt
- 3 years left (13th year since investing): 30% Equity + 70% Debt
- 2 years left (14th year since investing): 10% Equity + 90% Debt
- 1 years left (15th year since investing): 0% Equity + 100% Debt
The actual plan might differ depending on the goal type, market conditions and many other factors.
But in general, when long-term financial goals start becoming medium and short-term financial goals, you should slowly start de-risking your investments and reduce exposure to risky assets like equity. (Do read how real goal-based investing works to help you achieve your financial goals).
Traditionally, FDs and RDs have been the popular choice for short-term savings. But as you have seen, there are several other alternatives to fixed deposits that offer potentially higher tax-efficient returns than FD.
But I would still caution you: and say that the investment option that you chose for short-term goals should be such that you don’t end up taking unnecessary risk just for the sake of slightly higher returns. It may not be worth it as the goal is just a few years away and your life won’t change dramatically if you earn 1 or 2% more for just a couple of years.
Think about it.
Is there any reason other than laziness to invest in debt oriented balanced funds? From a tax perspective, it’s simply better to separately invest in debt and equity to get the LTCG tax benefits of equity. It doesn’t take a lot of effort to monitor the portfolio once a year (which one should do anyway).
But many people wish to keep number of products to bare minimum. And quite a many of such people would be the ones who are currently only using FDs and RDs for short term.
But fair point that you made.
Hi Dev, the clear distinction made by you between short and long term goals and how to invest differently for them is very well brought out in this post. Made for a good read.