Short-term vehicles are important in most investment and savings programs. They generate income, and the income can be quite high during periods of high interest rates. The primary function of these investments is to provide reserves that can be used for emergencies or to build up funds for some specific purpose. Most financial planners would recommend that anyone keep at least three to six months’ worth of after-tax income in short-term vehicles. This will allow an investor to cover unexpected needs or take advantage of attractive opportunities. Usually investors hold short-term vehicles in their portfolio as a temporary, highly liquid investment until a better opportunity comes along. Other investors are just more comfortable with them. That approach has its benefits during times of investment and economic instability.
Interest on Short-Term Investments – These investments can earn interest a couple of different ways. Some will pay a stated rate of interest, like savings accounts. Another way they earn interest is on a discount basis, which means a security is bought at a price below its redemption value, and the difference is the interest earned. U.S. Treasury bills is an example of a discount basis security.
Risk Characteristics – Most of these investments are considered to be low risk. The main risk posed to them is from inflation risk-the loss of potential purchasing power that happens when the rate of return on the investment comes short of the inflation rate. This has happened with passbook savings accounts and traditional bank savings accounts usually pay a low rate of interest and have no minimum balance. Most other short-term investments have higher rates of return that are about equal to or slightly higher than the average inflation rate. With short-term vehicles the risk of default, or nonpayment, is almost nonexistent. The reason is that the issuers of most short-term investments are highly reputable institutions, such as large banks and major corporations. Government agencies also insure deposits in commercial banks, savings and loans, savings banks, and credit unions.
Advantages and Disadvantages of Short-Term Investments – As stated before, these investments are highly liquid and low risk. They are available from local financial institutions and can easily be converted to cash with little inconvenience. Investors can also easily obtain higher returns as rates move up, but when interest rates go down, so do returns. The biggest disadvantage of them is their relatively low return. Because the risk is so low, returns on these investments average less than returns on long-term investments.