$4,000, $8,000, or Even $453,500 in 5 Years: A Low-Risk Investment Plan
How much can an investor accomplish in five years? Among the many possible answers, we're going to focus on two in this article: how much you could earn if you needed to use the money you invested at the end of those five years ($4k or $8k), and how much you could accomplish if those five years were used to give you a head start on a longer-term investment program ($453,500). (See also: How to Save $26,000 in 5 Years or Less)
Ready? Let's go.
A Five-Year Goal
Let's say you wanted to buy a house in five years and planned to spend the time between now and then building a down payment. Or maybe you realized your car had another five years left in it and you were planning to buy a replacement in five years.
Five years or less is a tough time horizon for an investor. It's not enough time to take much risk because if the market heads south, you don't have time to recover. On the other hand, tucking money into a super safe bank savings account isn't very appealing. Brick and mortar banks are offering just a small fraction of one percent as an "interest" rate. An online bank is a better choice, but not by much.
"Bond Funds. Short-Term Bond Funds."
So, what's a five-year investor to do? If Britain's most famous fictional spy were an investment, he would respond: "Bond funds. Short-term bond funds."
In essence, bonds are debt investments, as strange as that sounds. When governments, companies, and other entities want to raise money, one way they can do so is by issuing bonds. Investors send them money and the issuing organization promises to pay the money back with interest.
Among investments, bonds are on the safer side of the risk spectrum. However, investors can lose money with bonds if the issuing organization goes belly up. And, while this gets a little complicated — and boring — if you invest in bonds through a bond mutual fund, rising interest rates usually hurt bond fund values, especially long-term bond funds (those holding bonds that are due to be repaid a long time from now) — hence, my emphasis on short-term bond funds as a viable place to invest today for a five-year goal.
Recent Bond Fund Performance
Sound Mind Investing did an analysis of bond fund returns using various Vanguard funds, looking at all of the one-, three-, and five-year holding periods over the course of 25 years. Its analysis looked at six different bond fund "portfolios," with the one- to six-fund groupings designed to satisfy a range of risk appetites. Since each one consisted solely of bond funds, they were all, by definition, relatively low-risk.
The most conservative portfolio generated an average annual return of about 6% across all of the one-, three-, and five-year periods studied. The most aggressive portfolio generated an average annual return of about 8% across all of the periods.
Interestingly, none of the worst five-year annualized returns were negative. So, while past performance never guarantees future performance, it would be reasonable to assume a 6% annual return using bond funds to invest for your five-year goal.
$400 a Month
That means, if you invested $400 per month over the course of five years and were able to achieve a 6% average annual return, your $24,000 investment ($400 per month for five years) would turn into $27,908 — or nearly a $4,000 return.
Even better, if you had $24,000 to start with and could put the full amount to work using bond funds, assuming the same 6% annualized return, it would turn into about $32,370 — or a more than $8,000 return.
A Five-Year Head Start on a Much Bigger Number
Now let's look at this five-year time frame through a different filter. Let's say you're 20 years old, graduated early, and are starting your first full-time job. Your employer offers a 401(k) retirement savings plan that includes a generous dollar-for-dollar match on whatever you contribute up to 6% of your $48,000 annual salary (just a touch over the national median of $42,000 for entry level positions).
At first, you think you'll wait a while before taking part in the plan. You have some things you want to buy, some trips you'd like to take. And besides, you figure, you're young; you have plenty of time to save for an abstract goal like retirement when you're older.
Indeed, when you're 25, you finally start investing 10% of your salary. Assuming a very reasonable 7% average annual return, a 3% annual pay raise, and including your employer's match, by the time you're 65, you will have a nice nest egg of about $1,690,500.
But what if you decided to start setting aside 10% of your salary from your first day on the job? Keeping all the other assumptions the same, by age 65, you would have over $2,144,000.
By starting five years earlier, you would have contributed $26,250 more, but you would end up with $453,500 more!
To accomplish that, you could take an extremely simple approach of using a target-date fund, a type of fund that is now commonly available in workplace retirement plans.
While target-date funds are not perfect, they make some of the most important investment decisions for you.
For example, all you have to do is choose a fund with the year of your intended retirement date as part of its name (2060, again assuming you're 20 years old and want to retire at age 65). Since you have a long time to invest, a typical 2060 fund would be aggressively invested in mostly stocks. As you get older, it will automatically adjust this mix, adding bonds to become more conservative.
So, how much can you accomplish as an investor in five years? It depends on whether you need to use the money at the end of that time frame or simply use that time frame to get a head start on a longer investment program. Either way, you can accomplish a lot.
What financial goals have you set for the next five years? How are you planning to reach them? Please share in comments!