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The Best Savings Option for 2 - 3 Year Projects

By Austin Pryor with Joseph Slife
© Sound Mind Investing | August 2010
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If you took shop class in high school, you learned the principle of "having the right tool for the right job." That principle also applies to money management. Some savings/investing vehicles are suited for certain tasks, but not for others.

For emergency savings — money you might need at any time — bank money-market accounts (MMAs) and money-market mutual funds (MMFs) are the best choices. Such accounts often don't pay much interest (rates on some MMFs are close to zero right now), but the goal of these accounts isn't earnings. Rather, they exist as temporary holding places that keep your money safe and readily accessible.

But what about savings that you're setting aside for non-emergency purposes, such as a major purchase that's a couple of years (or more) away? Historically, a short-term bond fund has been a better "tool" for this type of job — but having at least a two-year time horizon is important.

Here's why. As interest rates fluctuate, short-term bond funds can temporarily suffer losses. However, while such funds will occasionally lose money over a span of several months, it is quite rare for them to lose money over a two-year period.

The table here shows the annualized performance over various two-year periods for four well-known short-term bond funds from Vanguard. For comparison purposes, a top money-market fund — Vanguard Prime — is also listed. (The risk level decreases as you move down the table — see "Relative Risk" column. A 1.00 reading indicates a fund with the same volatility as the overall market.)

The table includes the average, best, and worst performance for each fund based on 109 two-year holding periods. How did we come up with 109 if the table goes back only to 1999? By using "rolling" periods for tracking performance.

We began by looking at the results from buying on January 1, 1999, and holding for 24 months. Then we "rolled" to the next month to see what happened if the fund had been purchased on February 1 of that year and held for 24 months. Next, we moved to March 1 and did the same thing. Continuing in this way, month-by-month from 1999-2009, we computed the results for 109 24-month holding periods (in contrast to just 10 such periods if only "calendar years" were considered).

Using the rolling-periods approach gives a more accurate picture of the level of returns — and degree of volatility — that can be expected from an investment.

For instance, looking at the calendar-year performance columns in the table would seem to suggest that the worst performance for the Vanguard Short-Term Bond Index Fund occurred from 1/1/2004 through 12/31/2005 when the annualized return was 1.5%. But because investors don't buy bond funds only at the beginning of the year, that number is slightly misleading. As shown in the "Worst" column, the true worst-case two-year performance for that fund was actually an annualized return of just 0.71% (from 4/1/2004 through 3/31/2006).

Now that you understand the methodology behind the table, let's draw some conclusions. The table makes clear that over 24-month periods, odds favor getting a better result from a top-performing short-term bond fund than from a top money-market fund. The "Average" column shows that all of the four short-term bond funds handily beat Vanguard Prime during the past decade. Non-characteristically, the lowest-risk Federal government bond fund had better overall performance during the test period than the highest-risk corporate Investment Grade fund (see the "Average," "Best," and "Worst" columns), due in part to the financial turmoil of 2008-2009.

Even though the table shows that short-term bond funds tend to outperform money-market funds, we want to again stress that you can lose money in a short-term bond fund if you sell into a decline rather than holding for at least two years. In rare cases, you might even suffer a loss over a 24-month period (see the "Worst" column for Short-Term Investment Grade).

Occasionally, there may be periods when you would be slightly better off holding your savings in the more conservative money-market fund. Typically, however, short-term bond funds will outpace money market funds and accounts over a two-year period.

Keep in mind that a historical pattern can show only what the tendencies are — there's no guarantee those tendencies will hold up during any specific period. But if you're willing to endure a little more volatility in search of better returns for your accumulation savings and are committed to the recommended holding period, short-term bond funds are certainly worth a look. End

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