5 Year Investment Plan – College Fund, Down payment for House or Vacation Home? How to Invest for Medium Term Investment Goals

How to Invest for Medium-Term Goals with Index Funds

Key Takeaways

  • A 5 or 8 year time period is relatively short and a Medium-Term Investment Portfolio should be relatively simple with up to 3 ETFs
  • After assessing your Risk profile you can construct a portfolio quite easily and reduce costs/fees. What most people don’t realize is that this can be done without much financial knowledge
  • Unlike Long Term Investing your risks are higher due to the shorter time horizon and you need to pay extra attention to ETFs you select 
  • Select at least one Bond and one Equity ETF and rebalance quarterly or semi-annually

Table of Contents

Medium Term Personal Finance Investment Goals

Reach your goals and protect your capital

There’s plenty of advice when it comes to investing for retirement.

But what about your medium-term goals? What if you want to buy a house in five years? Or what if your child is heading to college in eight years?

Below are some examples of Medium Term  Personal Finance Investment Goals:

  • House downpayment
  • Wedding 
  • Gap Year Travel
  • Children Education

This article will help you construct an easy and cost-efficient ETF Portfolio to reach your goals and protect your capital

Two Building Blocks Core Portfolio

Key Ingredients for Financial Success

In order to construct a Medium Term Portfolio you need at least each of the following:

  • One US Market Equity ETF (#1) 
  • One US Aggregate Bond ETFs (#2) + Corporate Bond ETF (optional)

Example of Asset Allocation for Medium Term Investment Strategy​

The above allocation is an illustrative example of 5-Year portfolio for someone with some confirmed appetite for risk:

  • 30% is Allocated to Equity ETFs 
  • 70% to Fixed Income ETFs
  • An optional Corporate Bond ETF is added as part of the Fixed Income allocation to increase the Returns of the Fixed Income Allocation (you can keep the 70% in Blend Bonds)
Before You Start

UNDERSTAND YOUR NEEDS

How much money should I keep in Bonds?

  • Remember, knowing yourself and your goals matters most – you should always align your Portfolio with your objectives and that’s why this Portfolio should be individual and tailored to your needs and not benchmarked against other people you know
  • Take a questionnaire first to understand what Stocks/Bond allocation you need related to this specific goal
  • The questionnaire will take some key inputs like how soon is your deadline or how comfortable you are with the ups and down of the market (i.e. would you be comfortable seeing 30% of the money you’re saving up for a house disappear during a market crash?)
  • Use the results to buy the recommended ETFs below in the right proportions 
  • Understand that rebalancing of your portfolio is the key to being successful with any index  investment strategies

Allocation to Bonds is key for Medium Term Goals

Historical Probability of experiencing negative returns for a 60% Stocks 40% Bond Portfolio

mid term investing probablity of losses depending on time horizon - education emergency fund house down payment
Source: Bankeronwheels.com

Simulation of over 500 Portfolios from 1976 to 2020 of a 60% Stocks / 40% Bonds Allocation - Sudden losses can stir your emotional impulse to withdraw or suddenly change tack – no-one likes to see their portfolio go down in value – but staying put and resisting the temptation to tinker can pay off in the end. Chances of seeing a portfolio with ANY losses are drastically reduced if you hold a portfolio for over 4 years

  • Starting Investing Early for your Goal helps – remember, the longer the time horizon the lower the chances of losses in a stock market that goes up in the long term. Medium term investing can be tricky because time is just not sufficient enough to eliminate any chances by historical standards of losses 
  • But with the right asset allocation you can obtain the same no loss likelihood by increasing the allocation to Bonds e.g. historically you were not experiencing any losses for a 70% Bonds 30% Stocks Portfolio over 5 Years
  • You can gradually increase the allocation to Equities as your Investment Horizon gets longer above 5 Years 
READ  Long Term Investing Strategies for Financial Independence - How asset allocation will determine your Early Retirement

#1 Choosing an Equity ETF

ETF Benchmark Risk & Annual Returns (2000-2020)

These are Total returns including dividends from different US Asset Classes - US Equities generated about 7% per year including Mid and Small Caps

While for Long Term Investment Horizon International Exposure is necessary a 5-year Portfolio can be kept relatively simple with US Equities

US Market - do I need International Exposure?

  • US Equities represent c. 55% World Stock Capitalization and should be the cornerstone of the risky part of a portfolio 
  • S&P 500 companies are already diversified from a Revenue perspective – over 40% of Sales comes from Global Markets
  • US companies deliver high returns with lower risks (in terms of volatility but also operational risks like governance issues / fraud etc.)
  • US Dollar will remain the reserve currency at least in the short/medium term and foreign companies will be attracted in listing their Stocks on the largest Stock Exchange

Equity Market capitalization of Developed and Emerging countries

US part of global stock market capitalization
Source: FTSE Russell Index Data, Bankeronwheels.com

For a 5 Year Time Horizon I think that US Equities provide enough diversificaton without making the portfolio rebalancing too complex. You may further refine the Equity allocation by including some of the additional asset classes but US Large Caps already fulfill a lot of requirements for a short/medium term Investment Portfolio

The Easy Way

BUY THE WHOLE US MARKET

One ETF solution – the Total US Market ETF

Total Market ETFs cover all listed securities and thus capture the upper part of the graph that the largest Corporations (S&P 500) may not – over the long term this is the most prudent way of investing

Example of cheap Total Market ETF:

#2 Choosing a Bond ETF

Keep it simple

I like to keep investing simple. Bonds can be a bit intimidating due to their perceived complexity vs. Equities. But you probably only need one ETF to achieve your goals

The Easy Way

BUY AN AGGREGATE BOND ETF

One ETF solution – Blend Bond ETF

This is the easiest way of getting exposure to Bonds is through a high quality blend bond ETFS. This ETF is a broad market Bond ETF:

READ  Choosing the Best International ETFs for your Equity Portfolio (MSCI vs FTSE)

I suggest either of:

  • iShares Core US Aggregate Bond ETF (AGGfor Bonds (expense ratio of 0.04%)
  • Vanguard Total Bond Market ETF (BND) with slightly lower fee (expense ratio of 0.035%)
 

To understand the difference you can also have a quick comparison of main Aggregate Bond funds here.

Optional - Add some Yield

High Quality Corporate Bonds

  • Corporate Bonds provide you with higher income than Aggregate ETFs because they also have some default risk (albeit relatively low)
  • However, Corporates have a positive correlation with Equities hence it won’t protect you much during a downturn (see here how they reacted during COVID) so allocation should be quite modest

Current Yields on Bond ETFs (vs. Inflation)

As you can see from the chart below an Aggregate Bond ETF like BND will currently yield c. 1.5%

Read more about the Top Corporate Bond ETFs that FED is buying now or my comprehensive guide to Bond ETFs

best bond etfs how much interest can you get with bonds and inflation levels etfs index investing - comparison chart
Source: Bankeronwheels.com BOND ETF GUIDE

If you have a Time Horizon above 5 years you could add a small part of Portfolio Bond allocation to Pure Corporate Bond ETFs like VCIT or LQD that will increase your returns - click on the image above to review the Corporate Bond ETFs

#3 Optional - Additional ETFs

If you want to keep it simple you should stick to the above 2 ETFs.

However, you may be tempted to replace part of your Equity and Bond allocation with other asset classes. Here are a few observations.

Asset Class performance tends to move a lot

  • Below is the matrix ranking the asset classes by their returns each year and overall
  • In the below Matrix the “Bonds” box corresponds to the AGG ETF from the Core Portfolio
  • The S&P 500 can be a proxy for the Equity part of the Portfolio

Click here to read more about some of the conclusions 

A 10-Year Perspective

asset class returns matrix 2009 2019 gold nasdaq reits S&P dividend aristocrats corporates bonds treasuries TIPS
Source: Bankeronwheels.com

Adding other asset classes can singnificantly change the risk/return profile of your portfolio - be sure you're comfortable given your goals and time horizon

Alternatives for the Equity (Risky) Part of your 5 Year Investment Plan Portfolio

Some investors replace part of the US Equity ETF Allocation of the above Core Portfolio with some the below:

  • Nasdaq ETFs
  • Dividend Stock ETFs
  • Developed Markets ex-US ETFs
  • Emerging Markets 
  • Real Estate ETFs

Appendix - What can I expect?

What could have happened if I held longer or needed to sell earlier?

Holding a different mix of Stocks / Bonds wouldn’t have made a material difference to returns because Bonds had a few exceptional decades but the ranges of returns would have been materially reduced by adding Bonds (hence locking better returns for lower risk).

A 30% Stocks 70% Bonds portfolio:

  • Would have generated an average annual return of 9% since 1976
  • Would have experienced a worst scenario of positive 1%  annual return if held for 5 Years
  • The same portfolio could have had an annual loss of 1% in the worst case if held for 3 years instead of 5 Years
  • If the time horizon was lengthened to 10 Years the minimal worst case annual return would have been a positive 3%  
  • While we focused here on limiting downside risk, the below graph shows that there were some exceptional double digit annual returns in some scenarios
READ  How to invest in stocks during a Market Crash?

Historical annual returns and annual return ranges based on holding period (1976-2020)

historical returns medium time horizon index investing with etfs
Source: Bankeronwheels.com

The graph above incorporates over 1000 SCENARIOS (!) with ANY POSSIBLE entry point at the end of each month with different time horizons making it INDEPENDENT FROM THE STARTING POINT - the key takeaway is that no matter the market environment you need to hold your portfolio above 3 years to significantly reduce downside risks

What can I currently except?

Current investment environment is particularly difficult. Below are 3 scenarios:

  • Taking Historical Averages for both Stocks and Bonds (this is a benchmark since bonds won’t have the same returns). A 100,000 Investment returned historically on average 141,000 over 5 Years 
  • Taking 11.3% Annual Returns for S&P 500 and current Bond Yields – in this scenario the 100,000 Investment would return 125,600 in 5 Years 
  • Taking last 2 decades of S&P 500 Returns and current Bond Yields – in this scenario the 100,000 Investment would return 116,400 in 5 Years 

30% Stocks / 70% Bonds Portfolio Balance over time

Source: Bankeronwheels.com

Bond yields are currently so low that historical returns are inadequate and would overestimate the portfolio returns hence current Yield to Maturity is used as proxy - the most conservative scenario is in Orange based on historical averages. These returns could be enhanced if investing a small portion in Corporate Bond ETFs (here for simplicity only an Aggregate Fund is modelled)

POPULAR INVESTMENT GUIDES

My fundamental reviews of Equity ETFs and Asset Allocation include:

My fundamental reviews of Bond ETFs include:

DISCLAIMER

The views expressed in Bankeronwheels.com are my own personal views.

The information provided in Bankeronwheels.com is general in nature only and does not constitute personal financial advice. The information has been prepared without taking into account a reader’s personal objectives, financial situation or needs. Before acting on any information contained in Bankeronwheels.com you should consider the appropriateness of the information having regard to your objectives, financial situation and needs, and seek professional advice where appropriate.

I only talk about products, services and companies I like and use myself.

About Banker on Wheels 27 Articles
Ex Portfolio Manager and Institutional Advisor that witnessed first hand the 2008 GFC and the 2011 European Debt Crisis working for the most prestigious names in the financial industry. Currently on a bike around the world trip in a touring / backpacking mode and cycled close to 15,000 kms over the past year.
Subscribe
Notify of
guest
0 Comments
Inline Feedbacks
View all comments