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High Returns with Short-Term Investments

© Naeem Akhtar

Are the savings you'll need within a few years parked in money-market funds and CDs? You can do better.

In general, the longer you can keep your money working, the better your chance of reaping big returns. The investments with the highest payoff potential tend to give you the bumpiest ride. So to be sure they'll live up to their promise, you have to have the time, and the patience, to wait out downturnsBut what about cash you might need in five years or less, for emergencies or planned expenses? Money-market funds and CDs are practically mattress safe, but both offer meager returns--around 5 or 6 percent lately.

If you need your money back within two years, you may have few options. "Only money-market securities, CDs, or the very safest bond investments can provide enough assurance that the cash will be there in a couple of years," cautions financial planner Gary Schatsky of Albany, NY, and New York City.

Suppose your time frame is on the longer side of short--about three to five years. Then you have quite a few choices. If you're willing to stomach stock-market risk to maximize your returns, you could even opt for a portfolio of equities selected with short-term performance in mind (see page 163). But if you're more comfortable parking short-term cash in less volatile alternatives, consider the ones that follow: Bonds. Although generally less subject to wide price swings than stocks, bonds are by no means a sure bet. Their value fluctuates with interest rates; they can be called early, which cuts into your return; and they may not preserve all of your principal.

But even though bonds aren't risk-free, they're generally safer than equities, which makes them a traditional short-term play. And though bond returns aren't dramatic compared with those of equities, they can be reasonable.

Moreover, with municipals, you can usually have safety plus tax advantages. Of course, the advantage is greater in higher brackets. "For someone in the 28 percent federal tax bracket, a tax-free muni that pays 5 percent is equivalent to a taxable investment paying 7 percent," says Carol Wilson, a financial planner in Salt Lake City. "At 36 percent, it's equivalent to 7.8 percent." If the muni escapes state and local taxes, too, the equivalent figure would be even higher, Wilson notes.

You need not stick to very short-term maturities. Like many advisers, Wilson often recommends "laddering"--buying bonds with varying maturities, so that your holdings come due year by year. As one bond matures, you buy another to replace it and continue the cycle. This strategy gives you an opportunity to benefit from fluctuating interest rates, while reducing the volatility of your overall bond portfolio.