How to Choose Best Investment Option for Short Term Goals (2024)

In personal finance, we usually understand the term ‘investment plans’ as the same as the long-term investment plan. However, we have several short-term goals as well. For example, buying a phone, going for a vacation, paying back a short-term loan, purchasing a bike, etc., can be essential near-term goals in our lives. And we require a financial plan for these short-term goals as well.

This blog explains how to put together an investment plan for managing money over short periods. We look at what kind of investment instruments are suitable for short-term goals and how to select those products to help you plan your near-term goals.

Short Term Goals: How To Prioritize Them?

You can categorize all your short-term goals into two parameters: (1) the tenure of the goal, (2) the importance of the goal.

For instance, you can segment goals that are one week to 3 months away as emergency goals. Those goals which are 4-12 months away can be ultra-short goals. And then you can have short plans which extend from 1-3 years.

Once you bracket your goals as emergencies, ultra-short, and short-term goals, apply a layer of importance on top of each goal. For instance, goals like an emergency fund, school fees, loan installment, etc., are crucial. On the other hand, a vacation or an expensive phone can wait and are not that important.

When planning for short-term goals, this segmentation between time and importance can be helpful. As a thumb rule, the closer you are to your goals, and the more critical those goals are, the higher your allocation should be to those instruments that will not give you a nasty surprise.

Therefore, the money you have allocated for goals like your emergency fund, school fees, etc., should be invested or kept in only those instruments which have minimal risk. As we go along in this blog, we’ll detail the different types of financial products you can use for various scenarios.

Short Term Investments: Selection Criteria For Investment Products

When choosing an investment product for your short-term goals, there are three areas on which you should focus. The first aspect is the safety of capital, i.e., the money you put in should not carry any speculative or unknown risks. The second factor is liquidity, which means you should be able to redeem your investments instantly as and when required. And the third aspect to consider is the return potential against other comparable investment options.

To sum up, the three critical factors are safety, accessibility, and return ability.

Factor 1 – Safety Of Capital

Every investment carries some degree of risk. With mutual funds, the risk is the up and down movement of the NAV or net asset value. And with banks, it is the extreme and rare case of a collapse that can affect some part of your savings and fixed deposit balance.

So, while there is a risk, it is also essential to understand the extent and practicality of that risk. For instance, in the case of mutual funds, we looked at 6 different categories that investors generally consider for short-term investing. Within each category, we examined the highest-ranking scheme as per theETMONEY Fund Report Card.

The data in this table is from 2016 onwards. We wanted to understand the number of occasions when the fund had delivered negative returns. For instance, in the case of the L&T Overnight Fund, there has been only one instance in the last 1,808 days when the fund’s NAV fell from the previous day’s close. It gives the scheme a 99.99% positive occurrence value.

Similarly, other categories like liquid funds, ultra short term, and even money market funds seem to show reasonable levels of safety when measured on a daily return basis.

So to put this together, if you are looking for something super safe, look at a bank savings account or a bank fixed deposit. And within mutual funds, consider an overnight or a liquid fund for maximum safety.

Factor 2 – Liquidity Of Investments

The second consideration in our selection criteria is liquidity, i.e., the ease and speed at which you can withdraw your investments.

One of the fastest modes of accessing your money is a bank savings account, as it allows for online transfers and cash withdrawals over an ATM, bank branch, and even a point-of-sale terminal. And that’s where a good part of your emergency fund can go.

The second most accessible mode is a type of Debt Fund called Liquid Fund. Some funds in this category allow instant redemption up to a specific limit, and in addition, you can earn better returns than a savings account. Take, for instance, theETMONEY SmartDepositsolution. With ETMONEY SmartDeposit’s instant redemption feature, you get money in your account as soon as you put in the redemption request. However, in all other categories of Debt Funds, redeeming your units and the actual money hitting your bank account takes 1-3 business days between,

Next on the list of most liquid investments are FDs and other Debt Funds. In addition to investments, it might be a good idea to have a credit card or a line of credit that you may choose to pull money from in case of critical requirements, especially during medical emergencies.

Factor 3 – Return Potential Of Investment Products

The third and final selection criteria we need to consider are the returns. And what you typically look for is a better return than what a regular savings account or a fixed deposit might offer. Now, the returns on most debt instruments are dependent on the interest rates set periodically by the Reserve Bank of India.

As a thumb rule, fixed deposits and short-term debt funds tend to offer high returns when interest rates are high.

But as the interest rates bottom out, as they did in 2020 and 2021, most debt fund categories struggle to deliver returns per the investor’s satisfaction. And this holds not just for debt funds but also for fixed deposits and other small saving schemes like PPF, national savings certificate, etc.

In the case of debt funds, you need to be extra careful when anchoring on returns as a selection criterion because it’s pretty likely to get blindsided by it. Never forget that safety and liquidity have a higher role to play than returns while evaluating a debt fund. Moreover, don’t chase the best-performing fund as, more often than not, the funds that deliver the highest returns also take in the highest risk.

And lastly, when evaluating returns of Debt Funds, always look at post-tax returns. Taxes are significant when comparing fixed deposits with debt mutual funds because these instruments have different taxation structures. And while there are no visible tax benefits for the first three years, Debt Funds become attractive post 3 years, especially if you are in the 30% income tax bracket. To understand in detail the difference between the taxation of Debt Funds and FDs, you can read our blogFDs vs. Debt Funds.

Therefore, these 3 aspects – safety, liquidity, and return ability – lay the foundation for our selection structure. Let’s now get into specifics on how one can set up their short-term investments.

Setting Up Short Term Investments

The first step to set up your short-term investments is to align them to a goal. You can do it by creating SMART (specific, measurable, actionable, realistic, and time-bound) goals. And most importantly, write down these goals on a piece of paper or an excel sheet.

The simple act of writing down goals not only improves your decision-making process but also helps in giving you a clear picture of what types of investments you will need for each goal.

The next step is to allocate the right financial product to each of your short-term goals. For instance, the money allotted to important and immediate goals should be invested only in super safe instruments like a savings account, a fixed deposit, overnight funds, or liquid funds.

However, for the other goals that are not that important or are a little into the future, you can explore the slightly longer duration options like an ultra short term fund, a money market fund, and a low duration fund. You can also opt for anArbitrage Fund, suitable for parking money you need in 6-18 months.

The final step in building a framework for short-term investing is the actual selection of funds. There are two ways to identify suitable schemes. There is an easy way, and there is a complex way.

The easy way of shortlisting funds for investment is to use the ETMONEY Fund Report card, which ranks most schemes within a fund category. This feature incorporates many different variables like the credit quality of the scheme, the Sharpe ratio, the fund’sYTM or yield-to-maturity, the average maturity, etc. In fact, we use a total of 8 different variables to rank these schemes, and most importantly, the analysis incorporates the three principles of safety, liquidity, and returns.

The difficult way of selecting funds is to incorporate some checks and rules in your selection process manually. For instance, check number 1 will be looking at the modified duration. The lower that number, the better because the scheme is less sensitive to interest rate movements. And this is what you want in a short-term fund.

The second check is a fund’s average maturity. Check if a fund’s average maturity is equal to or lower than the category’s average maturity. It will help you determine if the fund has long-duration papers, adding additional risk to this portfolio. The third check revolves around the fund’s yield to maturity or YTM. The YTM of a fund shows the total rate of return that a debt fund can earn if it holds all its bonds until maturity. You should look at having a YTM that is close to the category’s average YTM.

It’s always very tempting to opt for schemes with a higher YTM. But that’s not a good idea in the case of short-term funds. Because a higher YTM almost always means that the fund is taking a higher risk by having low-rated paper or conducting some private debt placements, none of which serves your purpose.

So these were some pointers that you need to use in your assessment in addition to your research. And suppose you want a refresher on these terms. In that case, you can read our blog that explains everything aboutaverage maturity, modified duration, and other vital parameters to select a Debt Fund.

Bottom Line

To conclude, investing for the short term is very different from pro-equity long-term investing. Therefore, it is essential that you develop a proper framework, plan, and set up when deciding on investing for the short term.