The Smartest Way to Save for Near-Term Goals

Stocks and bonds don't make great short-term investments, so here's where to look instead.

Stocks and bonds can be fantastic places to invest money -- but not if you'll need that money within a few years. If you have some investable cash sitting on the sidelines, or if you plan on saving for a certain goal, but you can't risk losing any of it because of a short time frame, here's what you need to know about the best investment strategy for you.

Why short-term investment money should not be in stocks

If you'll need to access your money within a few years, your main priority should be preserving your capital, not returns on your investment. It's certainly nice for investments to do both, but your focus should be on making sure your money is available when you need it.

Stocks have the highest long-term return potential of any major asset class, historically averaging total returns of about 10% per year over periods of several decades. Over the short run, however, the stock market can be extremely volatile. Statistically speaking, a decline of as much as 22.8% in a single year wouldn't be considered unusual.

Let's say that you have $10,000 to put towards your child's education, but you won't need to pay the bill for another year. So you buy a S&P 500 index fund with the money in an effort to earn a nice return while you wait. However, what happens if the stock market drops by 20% over the year? Not only did you not earn a return as you had hoped, but you now only have $8,000 to help pay for tuition.

This is the main reason why most financial planners (myself included) advise staying away from stocks unless you won't need your money for at least five years.

Despite their reputation, bonds aren't much safer

If you'll need your money soon, stocks are out. So maybe bonds could be the way to go? After all, you can find long-term, highly rated corporate bonds that yield 4% or more.

Bonds have a reputation for being less risky than stocks. And it's true to some extent. Over time, bond returns are extremely predictable -- for example, if you buy a $1,000 bond that pays 5% interest and matures in 20 years, you know you'll receive $50 per year for the next two decades, and then you'll receive the initial $1,000 back.

However, despite their reputation, bonds can be just as risky as stocks over the short term. Without getting too much into the mechanics, when interest rates rise, the market value of long-maturity bonds drops. If you buy a 30-year Treasury bond or a 20-year corporate bond, for example, a spike in market interest rates can easily make a $1,000 bond worth $800 or less.

To be clear, short-term bonds don't have the same risk. However, as we'll see in the next section, short-term bonds aren't the best place to find risk-free short-term investments.

The smartest place for money you'll need soon

For money that you know that you're going to need at a certain time (within five years) a high-yield certificate of deposit, or CD, is the best choice. Thanks to the emergence of online banking and several Federal Reserve interest rate hikes over the past few years, you may be able to get a better yield than you think from a CD.

In fact, as I alluded to in the last section, you can find CDs from perfectly reputable institutions that pay more than Treasury securities of the same maturity.

Obviously, rates change over time, but just to give you an idea of how much the best CDs pay, here's a chart of different maturities and the yields you could get from Treasury securities.

Data sources: U.S. Treasury, The Ascent. Yields as of 6/18/19.

How to find the best CD for you

There's no such thing as a one-size-fits-all banking product, and that's certainly true for CDs. Some CDs have minimum deposit requirements, for example, while others may offer unique benefits such as a free FICO® Score. Our up-to-date list of the best CDs is a good place to start, but the thing to keep in mind is that it isn't only about the yield you get -- consider other features and perks as well.